fbpx

How Does an Iron Condor Work?

T here are so many options strategies at your disposal, giving you the opportunity to constantly learn and develop your trading skills. One of the more advanced strategies out there is the iron condor.  By learning what the iron condor is and how and when to effectively use it, you can determine whether it’s a good fit for you and your portfolio.

What Is an Iron Condor Option?

Image via Unsplash by austindistel

An iron condor is a strategy for trading options that involves two different credit spreads in the same trade. Each spread uses two calls and two puts, with one in each set being a long position and the other being a short position, all of which have four separate strike prices but share the same expiration date.

When traders use this strategy, they’re hoping to profit from an underlying asset’s low volatility. Put simply, the iron condor strategy yields the highest returns when, at expiration, the underlying asset closes somewhere around the middle strike prices.

When creating an iron condor, investors can create positions on individual stocks or indexes of any size, but the underlying asset is frequently one of the broad-based market indexes. The iron condor differs from a regular condor spread because it uses calls and puts instead of just one or the other. Aside from that, both the condor and iron condor have similar payoffs and are extensions of the butterfly and iron butterfly strategies.

How Does an Iron Condor Work?

To construct an iron condor, traders:

  1. Purchase an out-of-the-money (OTM) put that has a strike price that’s less than the underlying asset’s current market price. This option will shield the investor from a significant downturn for the underlying asset.
  2. Sell one at-the-money (ATM) or OTM put with a strike price that is a bit closer to the underlying asset’s current market price.
  3. Sell one ATM or OTM call with a strike price that is above the underlying asset’s current market price.
  4. Purchase one OTM call with a strike price that exceeds the underlying asset’s current market price even more than the call they sold. This option will shield the investor from a significant spike for the underlying asset.

The low and high strike options that are further out of the money are both long positions. These options are often referred to as the strategy’s ‘wings.’

Since the wings shield the trade against any significant fluctuations in either direction, this strategy gives traders a position with minimal upside or downside risks.

The wings have lower premiums than the written options because they are further out of the money. As a result, a net credit is placed on the account when the trade is placed. When using this strategy, traders hope that all of the options will expire completely worthless. This is only possible if the underlying asset closes somewhere around the middle strike prices at the expiration date. If the trade is successful, there’s usually a fee to close it. Even if the trade isn’t successful, the losses are still contained.

Traders can also make their strategy lean more bearish or bullish when selecting the different strike prices. For example, a trader might hope for a small upside turn in the underlying asset’s price before expiration if they set both of the median strike prices above the current market price. This strategy still offers limited risks and rewards.

The Profits and Losses of the Iron Condor Strategy

An iron condor has a limited amount of profit potential due to the strategy’s limited amount of risk. It’s also important to note that because there are four different options involved with this strategy, the commission you pay can be pretty substantial.

The profits enjoyed through an iron condor are limited to the credit, or amount of premium, that the trader receives for making the four-leg options position. Aside from having capped profits, the losses are limited to the difference between the long and short strikes for both the call and put positions. A maximum loss would occur if the underlying asset’s price exceeded the long call strike or dipped below the long put strike.

After accounting for this difference, you would subtract the net credits received from placing the wings and add up the commissions owed for the trade to get a complete view of the loss.

When to Use an Iron Condor

Options traders typically fall into one of two categories: volatility or directional. While a volatility trader prioritizes how much they think a stock will move in either direction, a directional trader is concerned with whether they think a particular stock will go up or down.

The iron condor is what is known as a ‘delta-neutral’ options strategy because it doesn’t really matter if the stock moves. Instead, what matters is how much it moves.

Directional traders favor this strategy when they believe that a stock or index is going to be range-bound. You sometimes see directional traders employing this strategy right after earnings. For example, once a stock takes a pretty big hit for an extended period of time, there’s usually a stretch when shorts and longs hit a stalemate, causing the stock to sit there pretty lifeless for a while. Traders who rely on technical analysis also make use of this strategy by using the levels from their support and resistance lines to create their iron condor.

Volatility traders like to use the iron condor strategy when they think a stock or index has a particularly notable implied volatility. This strategy is especially popular around earnings season. Since an iron condor has a clearly defined and capped risk, having short volatility before earnings is a little less scary. Because things are especially uncertain before an earnings announcement, the premiums on options are usually inflated, allowing volatility traders to collect higher premiums.

The Advantages and Disadvantages of Using the Iron Condor Strategy

As with any other trading strategy, there are pros and cons associated with the iron condor.

Advantages of the Iron Condor

Some of the benefits of using this strategy include:

  • You can collect twice the premiums. The iron condor gives you the chance to collect double premiums since you’re setting up a put and a call spread.
  • Half of the trade gives you guaranteed returns. You have guaranteed maximum profits on half of the trade, regardless of how things turn out.
  • You can react to changes as they happen. Options trading is extremely versatile, and the same is true of the iron condor trading strategy. If the underlying asset experiences a big shift, you could purchase back the suffering short options while allowing its corresponding long option to stay open. That way, if the stock continues in the same direction, the long option’s value will increase, balancing out, or even reversing any losses.

Disadvantages of the Iron Condor

A few of the iron condor’s challenges are:

  • There are two times the number of ways you can lose. Since you’re hoping that a stock will stay within a very specific trading range, you are essentially doubling the chances that you will lose money.
  • The losses can be substantial. The potential losses, though capped, can outweigh the potential profits.
  • There’s a risk of over-leveraging. Since the capital needed for this strategy is so minimal, traders sometimes fall into the trap of over leveraging by setting up more iron condor positions than they should.

T here are a number of ways to profit from options trading, so it’s beneficial to get acquainted with the strategies at your disposal before you get started. Though the iron condor is a more advanced options strategy, it is an extremely useful way to manage the risks associated with trading and ensure profits.