The Iron Condor Trading Strategy Guide

The Iron Condor Options Strategy

Introduction:

The iron condor is a limited risk option trading strategy that is designed to earn a small limited profit. Iron condor utilizes two vertical spreads – a put spread, and, a call spread.

(A put vertical spread involves buying, and, selling of equal quantities of puts – of same expiration but different strikes; of an underlying asset. A call vertical spread involves buying, and, selling of equal quantities of calls – of same expiration but different strikes; of an underlying asset. A vertical spread can be bullish or bearish; and, can be for debit or credit of the premium.)

Generally, an iron condor is constructed using out of the money options.

Iron condor strategy involves:

A – Buying and selling of Call, and, Put options.

B – Involves four different option contracts.

C – All options have the same underlying asset with the same expiry date.

Based on the perceived volatility of the underlying security, two types of iron condors can be constructed:

1- Long Iron Condor – is profitable when the underlying asset is perceived to have low volatility.

Iron Condor

2- Reverse (or Short) Iron Condor – is profitable when the underlying asset is perceived to have high volatility.

 


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Long Iron Condor**

The long iron condor is a non-directional limited risk option trading strategy which has a larger probability of earning a smaller limited profit when the underlying asset is supposed to have a low volatility.

Construction:

Using options expiring on the same date, the option trader can construct a long iron condor by:  

Selling 1 Out of the Money Call   

Buying 1 Out of the Money Call – Higher Strike              

Selling 1 Out of the Money Put      

Buying 1 Out of the Money Put – Lower Strike

The difference between the call strikes will generally be the same as the difference between the put strikes.                  

This gives a net credit of the premium to the trader.

Payoff for the Long Iron Condor:

When the underlying asset is expected to have low volatility, this strategy has a higher possibility of generating a limited profit. In case, the volatility increases, the loss is limited. Thus, this is a limited loss, and, limited profit strategy.

Max Profit:

Max Profit = Net Premium Received – Commissions Paid; and this happens if on expiry the underlying asset is in between the strike prices of the sold call, and, the sold put.  

Max Loss:

Max Loss for the long iron condor is limited but significantly higher than the maximum profit. Max loss would occur in either of the two scenarios:

1 – On expiry, the underlying asset closes at or above the bought Call Strike, and, it can be calculated as:

Max Loss = Difference between the Call strike sold and the Call strike bought, less Net Premium Received, plus Commissions Paid

Or

2 – On expiry, the underlying asset closes at or below the bought Put Strike, and it can be calculated as:

Max Loss = Difference between the Put strike sold and the Put strike bought, less Net Premium Received, plus Commissions Paid

Breakeven:

There are two breakeven points:

Upper Breakeven Point = Strike Price of Short Call + Net Premium received

Lower Breakeven Point = Strike Price of Short Put –  Net Premium received

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When to Execute:

This strategy should be executed when the trader expects the volatility to be low.

The strategy generates profit if the underlying asset expires in between the strike prices of the sold call, and, the sold put. Thus, this strategy should be executed when the trader anticipates the volatility to be low; so that the underlying asset would expire within the the strike prices of the sold call, and, the sold put.

The goal is to earn as much premium as possible on the sold options.

With the passage of time, option premiums decay; and, hence the best time to execute this strategy would be at least two to three days before the expiry; for weekly options – this is not a strict rule though; and, the trader needs to consider the volatility.

Remember to execute this strategy on a stock which has high liquidity, as the trader runs the risk of assignment on the sold options.

Example 1:

Suppose, stock A is trading at $50 in July. An options trader constructs a long iron condor by:

1 – Selling a July 55 Call for $100

2 – Buying a July 60 Call for $50

3 – Selling a July 45 Put for $100

4 – Buying a July 40 Put for $50  

Iron Condor example            

Payoff Diagram:

Iron Condor Payoff    

  • On expiry, if the stock A is still trading at $50

All the options expiry worthless, and the trader gains the entire Net Premium received ($100). This is the maximum profit the trader can make.

  • On expiry, if the stock A is trading at $60

All the options except the sold July 55 Call expire worthless. The July 55 Call will have an intrinsic value of $500. Subtracting the Net Premium received from $500, the trader suffers the maximum loss of $400.         

  • On expiry, if the stock A is trading at $40

All the options except the sold July 45 Put expire worthless. The July 45 Put will have an intrinsic value of $500. Subtracting the Net Premium received from $500, the trader suffers the maximum loss of $400.

Effect of Volatility:

If the volatility increases, and, the underlying asset expires outside the range of strike prices of the sold call, and, the sold put, this strategy would result in a loss. Hence, increase in volatility, everything else being the same, would have a negative impact on this strategy.

Effect of Time Decay:

The passage of time, everything else being the same, would have a positive impact on this strategy.

With the passage of time, option premiums decay. As this strategy gives a net credit of the premium to the trader, passage of time helps the trader to earn premium due to the time decay of the premium.

*Assignment Risk:

The sold options run the risk of getting assigned/exercised, at any time. Should this happen, the trader can decide to either close out the resulting position in the market, or, to exercise one of the options (Put or Call – as the case be).

Example 2:

Suppose, Google is trading at $918.59 on July 7, 2017, and the options expire on July 14, 2017.  

An options trader expects the volatility to be low; and, thus, constructs a long iron condor by:

1 – Selling a July 920 Call for $8

1 – Buying a July 922.5 Call for $7.50

3 – Selling a July 917.5 Put for $7.10

4 – Buying a July 915 Put for $6.30    

   Iron Condor example

For this position, the maximum loss is $120, and the maximum gain is $130.

The table below shows the payoff; at different prices of Google, on expiry.

Iron Condor payoff

Payoff Diagram:

*Assignment Risk:

The sold options run the risk of getting assigned/exercised, at any time. Should this happen, the trader can decide to either close out the resulting position in the market, or, to exercise one of the options (Put or Call – as the case be).

Reverse (or Short) Iron Condor**

The reverse (or short) iron condor is a limited risk-limited profit option trading strategy which generates a profit when the underlying asset makes a sharp move in either direction.

Construction:  

Using options expiring on the same date, the option trader can construct a short iron condor by:

Buying 1 Out of the Money Call   

Selling 1 Out of the Money Call – Higher Strike               

Buying 1 Out of the Money Put     

Selling 1 Out of the Money Put – Lower Strike       

The difference between the call strikes will generally be the same as the difference between the put strikes.                  

This results in a net debit of the premium.

Payoff:

When the underlying security is expected to have high volatility, this strategy has a higher possibility of generating a limited profit. In case, the volatility remains low, the loss is limited. Thus, this is a limited loss, and, limited profit strategy.

Max Profit:

Max profit for the reverse (or short) iron condor is limited but significantly higher than the maximum loss.

Max profit would occur in either of the two scenarios:

1 – On expiry, the underlying asset closes at or above the sold Call Strike, and it can be calculated as:

Max Profit = Difference between the Call strike bought and the Call strike sold, less Net Premium Paid, minus Commissions Paid

Or

2 – On expiry, the underlying asset closes at or below the sold Put Strike, and it can be calculated as:

Max Profit = Difference between the Put strike bought and the Put strike sold, less Net Premium Paid, minus Commissions Paid

Max Loss:

Max loss is limited, and can be calculated as

Max Loss = Net Premium Paid + Commissions Paid; and this happens if on expiry the underlying asset is in between the strike prices of the long (bought) call, and, the long (bought) put.  

Breakeven:

There are two breakeven points:

Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid

Lower Breakeven Point = Strike Price of Long Put –  Net Premium Paid

When to Execute:

This strategy should be executed when the trader expects the volatility to be high.

The strategy generates profit if the underlying asset expires either at or above the sold call, or, at or below the sold put. Thus, this strategy should be executed when the trader anticipates the volatility to be high; so that the underlying asset expires either at or above the sold call, or, at or below the sold put.

Remember to execute this strategy on a stock which has high liquidity, as the trader runs the risk of assignment on the sold options.

Example 3:

Suppose, stock A is trading at $50 in July. An options trader constructs a long iron condor by:

1 – Buying a July 55 Call for $100

2 – Selling a July 60 Call for $50

3 – Buying a July 45 Put for $100

4 – Selling a July 40 Put for $50                        

Iron Condor example

Payoff Diagram:

                  

  • On expiry, if the stock A is still trading at $50

All the options expiry worthless, and, since the trader had taken a debit of $100 on constructing the trade, the trader incurs a loss of $100. This is the maximum possible loss for this position.

  • On expiry, if the stock A is trading at $60

All the options except the bought July 55 Call expire worthless. The July 55 Call will have an intrinsic value of $500. Subtracting the Net Premium paid ($100) from $500, the trader gains $400.

  • On expiry, if the stock A is trading at $40

All the options except the bought July 45 Put expire worthless. The July 45 Put will have an intrinsic value of $500. Subtracting the Net Premium paid ($100) from $500, the trader gains $400.

Effect of Volatility:

Increase in volatility would help the underlying to expire either at or above the sold call, or, at or below the sold put. Hence, increase in volatility, everything else being the same, would have a positive impact on this strategy.

Effect of Time Decay:

The passage of time, everything else being the same, would have a negative impact on this strategy.

With the passage of time, option premiums decay. As this strategy results in a net debit of the premium to the trader, the passage of time will result in loss of premium to the trader; due to the time decay of the premium.

*Assignment Risk:

The sold options run the risk of getting assigned/exercised, at any time. Should this happen, the trader can decide to either close out the resulting position in the market, or, to exercise one of the options (Put or Call – as the case be).

Example 4:

Suppose, Amazon is trading at $978.76 on July 7, 2017, and the options expire on July 14, 2017.  

An options trader expects the volatility to be high; and, thus, constructs a reverse (or short) iron condor by:

1 – Buying a July 982.5 Call for $8.53

1 – Selling a July 985 Call for $7.80

3 – Buying a July 975 Put for $7.82

4 – Selling a July 972.5 Put for $7.65       

For this position, the maximum loss is $90, and the maximum gain is $160.

The table below shows the payoff; at different prices of Amazon, on expiry.

Payoff Diagram:

*Assignment Risk:

The sold options run the risk of getting assigned/exercised, at any time. Should this happen, the trader can decide to either close out the resulting position in the market, or, to exercise one of the options (Put or Call – as the case be).

Conclusion

There is a considerable disagreement among experienced traders on how the terms long, and, short apply to the iron condor spreads. Hence, it would be wise to communicate exactly, and, clearly the position which is being taken.

I hope you enjoyed this post on the Iron Condor.  Please do not hesitate to email me with any questions or comments :).

-J Crawford

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