Introduction To Iron Condor Option Strategy
The iron condor is not to be confused with iron butterfly and condor. The iron condor is a combination of a bull put spread and a bear call spread. It is a strategy that projects low volatility on the underlying security. When the volatility of the underlying security is low, the trader can earn a limited profit. The iron condor is created from options expiring in the same month and results in a net credit.Hence, the trader receives a net premium from the trade when it is executed. The iron condor belongs to a family of options strategies called wingspreads whose risk/reward profiles resemble birds with wings.
A Net Debit
An iron condor strategy will usually result in a net debit.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Low volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited losses and risk
Step 7 : Loss calculation
Step 8 : Limited profit
Step 9 : Maximum profit calculation for an iron condor
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade
Step 12 : General guidelines for exiting the iron butterfly trade
Step 1 : Perform economic, fundamental and technical analysis
By doing the above, one is able to judge if the markets and the underlying security will be volatile in general. The trader should look out for patterns such as:
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 : Outlook – Low volatility
The security underlying the options is projected to have low volatility. If the security stagnates, the trader stands to earn a limited profit.
Step 3 :Study the option chain
Examine the options chain and determine the options to use in the construction of the iron condor.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
At the breakeven price points, there is neither profit nor loss. A trader that intends to execute the iron condor strategy takes note of the breakeven price points before the execution. He mentally notes these price points and knows the range of security prices that will result in a maximum profit.
There are 2 breakeven price points. The upside breakeven point and the downside breakeven point.
The upside breakeven point = Net credit received + Exercise(strike) price of written call
The downside breakeven point = Exercise(strike) price of written put – net credit received
Step 5: Understand Your Profit Zones
After calculating the breakeven points, one is able to know where the profitable zone is. The profit zone for an iron condor is between the breakeven points.
Step 6 : Limited losses and risk
If you study the risk-reward profile, you will find that the potential maximum loss of the strategy is greater than the potential maximum profit. The maximum loss occurs when the price of the underlying security is:
- greater than or equal to the exercise(strike) price of the long call
or
- less than or equal to the exercise(strike) price of the long put
Step 7 : Loss calculation
In this case, we are calculating the maximum loss of an iron condor. The maximum loss can be calculated as :
Difference between the exercise(strike) prices of the long and short calls + commissions paid to the broker – net credit received
or
Exercise(strike) price of the bought call – Exercise(strike) price of the written call + commissions paid to broker – net credit received
Step 8 : Limited profit
The iron condor options strategy is a limited profit strategy. It is structured in such a way that the maximum profit is realised when the price of the underlying security trades between the exercise(strike) prices of the shorted options i.e. trades between the exercise(strike) price of the short put and the short call. Beyond that band of exercise(strike) prices, the strategy’s profit decreases and could turn into a loss making trade.
Step 9 : Maximum profit calculation for an iron condor
The maximum profit can be calculated as:
Net credit received – commissions paid to broker
Step 10 : Calculate Risk & Reward Ratio
After calculating maximum profit and loss, calculate the risk and reward ratio to ascertain the relative attractiveness of the trade compared to other strategies.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade
All options bought and sold for the iron condor are of the same expiration month and hence, have the same time remaining to expiry. To execute an iron condor, a trader will:
- Write 1 out of the money put option contract
- Long 1 out of the money put option contract with a lower strike price
- Write 1 out of the money call option contract
- Long 1 out of the money call with a higher strike price
The above, if executed, can be considered as a set in itself. Traders can execute multiple sets. For example, a trader can execute 10 sets, that is:
- Write 10 out of the money put option contract
- Long 10 out of the money put option contract with a lower strike price
- Write 10 out of the money call option contract
- Long 10 out of the money call with a higher strike price
But of course, the trader that executes multiple sets stands to make a greater loss if the price of the underlying security is greater than or less than the upper and lower breakeven points respectively.
Step 12 : General guidelines for exiting the iron butterfly trade
- If the iron condor is profitable, a trader may want to close the trade, especially if the trade has a reasonable profit, less than or 30 days to expiration and if market sentiment has changed that would cause volatility in the days to come.
- If the price of the underlying security is trading below the downside breakeven point, the trade is in loss territory. The trader can take a loss at this point if the underlying security is expected to trade below the downside breakeven.
- If the price of the underlying security is trading above the upside breakeven point, close out the position to avoid assignment.In this range, the trade is in loss making territory.
- If assignment occurs, exercise the long position options to cover the assigned underlying.
Step 13 : Record Trade In Diary
Next, it is advisable to record, analyse and reflect on the trade to sharpen one’s skills as a trader, to make refinements to the trade process and to become a better trader.
Example Of An iron Condor
The price of GGG Corp is trading at $60. A trader creates an iron condor by:
- Write 1 December 55 put option contract @ $2
- Long 1 December 50 put option contract @ $1
- Write 1 December 65 call option contract @ $2
- Long 1 December 70 call with a higher strike price @ $1
The net credit received is ($2 + $2 – $1 – $1) x 100 = $200
If the price of the options trade at $60 on expiration, the maximum profit is thus the net credit received.
| Beginning value | End value | Profit or loss | |
| Dec 55 put | $2 | $0 | Profit = $2 |
| Dec 50 put | $1 | $0 | Loss = $1 |
| Dec 65 call | $2 | $0 | Profit = $2 |
| Dec 70 call | $1 | $0 | Loss = $1 |
| Overall profit | Overall profit = $2 |
As you can see when the price of the underlying security trades between $55 and $65, the trader can realise a maximum profit of:
$2 x 100 = $200
This, as explained above, is also the trader’s net credit.
If the price of GGG trades at $50 on expiration :
| Beginning value | End value | Profit or loss | |
| Dec 55 put | $2 | $5 | Loss = $3 |
| Dec 50 put | $1 | $0 | Loss = $1 |
| Dec 65 call | $2 | $0 | Profit = $2 |
| Dec 70 call | $1 | $0 | Loss = $1 |
| Overall loss | Overall loss = $3 |
As you can see the overall loss here in this case is the maximum loss. The maximum loss can also be calculated as exercise(strike) price of long call – exercise(strike) price of short call – net credit.
$70 – $65 – $2 = $3
If GGG trades at $70 on expiration:
| Beginning value | End value | Profit or loss | |
| Dec 55 put | $2 | $0 | Profit = $2 |
| Dec 50 put | $1 | $0 | Loss = $1 |
| Dec 65 call | $2 | $5 | Loss = $3 |
| Dec 70 call | $1 | $0 | Loss = $1 |
| Overall loss | Overall loss = $3 |
As you can see in this case, the overall loss is also $3. This is also the maximum loss of the trade. The maximum loss occurs when:
- The trading price of the underlying security is greater than or equal to the exercise(strike) price of the bought call
or
- The trading price of the underlying security is less than or equal to the exercise(strike) price of the bought put
Read: