Reverse Iron Condor : Profit From Increased Volatility

Introduction To Reverse Iron Condor Option Strategy

Reverse Iron Condor

The reverse iron condor is an options trading strategy that is created with both puts and calls derived from the same underlying security and have the same expiration date. The end result is that the reverse iron condor’s potential profit and loss are both limited. To create a reverse iron condor, a trader will:

  • Write an out of the money put @ strike price S1
  • Buy an out of the money put @ strike price S2
  • Buy an out of the money call @ strike price S3
  • Write an out of the money call @ strike price S4

At the time of execution, the price of the underlying security is trading between S2 and S3. S1, S2, S3 and S4 represents the exercise(strike) prices of the options in increasing order. Therefore:

S1 < S2 < S3 < S4

Net debit trade

When the reverse iron condor is executed, there is a resultant net debit. That means that there is a net outflow of monetary resources used to establish the trade. Simply put, the options trader has to pay to establish the reverse iron condor trade. The reason for this is that the total options premium for long positions is greater than the total options premium for short positions.

Short condor vs reverse iron condor

A short condor is an options trading strategy that has a similar payoff diagram with the reverse iron condor, created to take advantage of high volatility. A trader may wish to study the short condor strategy as well. Other strategies that should be studied include short put butterfly and short butterfly.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook : Anticipate Increased Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Loss
Step 7 : Maximum loss calculation for  reverse iron condor
Step 8 : Potential for limited profit
Step 9 : Maximum profit calculation for reverse iron condor
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up A Reverse Iron Condor
Step 12 : Exit Trade & Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

The options trader should anticipate economic and fundamental events that may cause the price of the underlying security to be volatile. Hence, economic analysis and fundamental analysis can aid an options trader in determining where the price of the underlying security is headed. With technical analysis, the trader is able to determine approximate entry and exit points as well. Here are some suggested chart patterns to look out for:

 

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 : Outlook : Anticipate Increased Volatility

A trader that executes a reverse iron condor anticipates increased volatility in the price of the underlying security. If he is right, he stands a chance of earning a maximum but limited profit. This is evident from the risk/reward profile of the reverse iron condor. Hence, the greater the volatility of the price of the underlying security, the greater the probability of earning the maximum profit.

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Step 3 :Study the option chain

Examine the options chain and look at the options that are to be used to create the reverse iron condor.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

After deciding on which options to use, the options trader is able to calculate the breakeven points as the premiums on the options are known.

There is an upside breakeven point and a downside breakeven point in a reverse iron condor.

At these price points, there is neither loss nor profit from the trade. This is also reflected in the payoff diagram.

The downside breakeven point can be calculated as :

Strike price of bought put – net debit

The upside breakeven point can be calculated as:

Strike price of bought call – net debit

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Step 5: Understand Your Profit Zones

Reverse Iron Condor

The breakeven points will tell a trader where the profit zone is. For a reverse iron condor, it is any price point to the right of the upside breakeven point and any price point to the left of the downside breakeven point.

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Step 6 : Loss

A loss is experience between the breakeven points. This loss is capped.

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Step 7 : Maximum loss calculation for  reverse iron condor

The maximum loss of a reverse iron condor can be calculated as :

Net debit + commissions paid to broker

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Step 8 : Potential for limited profit

The reverse iron condor only has limited profit potential. The maximum profit attainable is higher relative to the maximum loss attainable. The maximum profit is realisable when the price of the underlying security is:

  • less than the exercise(strike) price of the written put
  • greater than the exercise(strike) price of the written call

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Step 9 : Maximum profit calculation for reverse iron condor

The maximum profit can be calculated as:

Strike price of long put – strike price of short put – net debit – commissions paid to the broker

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Step 10 : Calculate Risk & Reward Ratio

After the maximum profit and loss is calculated, the risk and reward ratio can be calculated. This gives the options trader a quantitative measure of the attractiveness of the trade relative to trades of a similar nature.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up A Reverse Iron Condor

After doing the necessary, it is now time to execute the reverse iron condor. The reverse iron condor can be execute. Refer to the introduction above to find out which strike prices are involved in a reverse iron condor.

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Step 12 : Exit Trade & Record Trade In Diary

Next, exit the trade and record the trade’s performance in a diary or a journal. Reflect on the performance and find ways to improve future trades.

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Example Of Reverse Iron Condor

ZZZ Corp is trading at a price of $75. A trader believes that the price of the underlying security will be quite volatile in the weeks ahead. He executes a reverse iron condor by:

  • Shorting a December 65 put @ $0.70
  • Buying a December 70 put @ $1.20
  • Buying a December 80 call @ $1.20
  • Shorting a December 85 call @ $0.70

Note that the trading price of ZZZ trades at $75, which is in between $70 and $80.

When the above reverse iron condor trade is executed. a net debit results. The net debit is:

($1.2 x 2 – $0.7 x 2) x 100 = $100

This is the amount that is deducted from the traders brokerage account.

The worse thing that can happen when a reverse condor is executed, is when prices of the underlying security stagnates. When that happens, all the options involved in the trade expire worthless and the trader loses his net debit of $100. Please refer to the table shown below.

Beginning value Ending value Profit(+) or Loss(-)
Short December 65 put $0.70 $0 +$0.70
Buy December 70 put $1.20 $0 -$1.20
Buy December 80 call $1.20 $0 -$1.20
Short December 85 call $1.20 $0 +0.70
Overall loss -$1

A $1 per share loss also means and overall loss of $100 as every option contract has an underlying security of 100 shares in this case.

If the price of ZZZ trades at $65 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
Short December 65 put $0.70 $0 +$0.70
Buy December 70 put $1.20 $5 +$3.80
Buy December 80 call $1.20 $0 -$1.20
Short December 85 call $1.20 $0 +0.70
Overall profit +$4

The overall profit in this case is $400. We calculate it as:

$4 x 100 = $400

If the price of ZZZ trades at $85:

Beginning value Ending value Profit(+) or Loss(-)
Short December 65 put $0.70 $0 +$0.70
Buy December 70 put $1.20 $0 -$1.20
Buy December 80 call $1.20 $5 +$3.80
Short December 85 call $1.20 $0 +0.70
Overall profit +$4

In this case, the overall profit is still $400.

$400 is also the maximum possible profit of the reverse iron condor in this particular example.

The maximum profit occurs when the price of the underlying security is:

  • less than or equal to $65 (lowest strike price)

OR

  • greater than or equal to $85 (Highest strike price)

Let us compare maximum profit and the maximum loss.

Maximum profit Maximum loss
$400 $100

From the table above, you should be able to tell that the maximum profit of a reverse iron condor is greater in magnitude than the maximum potential loss. This is a characteristic of the reverse iron condor. A trader who executes this strategy takes note of this before he executes his trade.

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