Basics Of Iron Condors

Posted by jbrumley on November 10, 2015 9:57 AM

Iron Condors

Iron condors are a type of limited risk option trading strategy that involve multiple spread trades, prompted by an assumption that the underlying stock or index will see little to no net movement through the options' expiration, with the ultimate goal of seeing all the options expire worthless which will allow a trader to retain the entire net-credit garnered at the initial entry of the position.

An iron condor trade is comprised of two different spread trades... a credit call spread using calls with strike prices above the underlying stock's or index's price, and a credit put spread using strike prices below the underlying stock's or index's current price. An equal number of contracts of each of the four option are traded, and usually, the difference between the two strikes for the put spread is the same as the difference between the strikes on the call spread trade.

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An example will better illustrate the use of iron condors.

Let's assume we think the Procter & Gamble (PG) shares are going to remain at or near a price of $75 through July. In order to capitalize on that expectation, we would place trades like (the same number of contracts for all four pieces of the trade)...

  • Buy PG July 95 calls at $110
  • Sell PG July 85 calls at $170
  • Sell PG July 65 puts at $160
  • Buy PG July 55 puts at $100  

These four trades combined would net income of $120 at the onset of the trade. And, as long as PG shares remained about $65 or below $85 through July's expiration, the iron condor trade will allow the iron condor trade to net that $120 profit... the maximum possible profit.

If Procter & Gamble shares move above $85 or below $65 before the options expire, however,  that maximum profit is increasingly jeopardized as the risk of either the 85 calls or the 65 puts being exercised against the trader rises. In most cases, the net-gain would effectively turn into a net-loss before the price of $95 or $55 was met. At or beyond either of those prices, the maximum loss has already been completely achieved. For that reason, it's usually preferable to close out one side of the trade or the other - even if part of the maximum profit is given back - if at appears PG is poised to move above $85 or below $65.

Iron condors are named as such because of the shape of the profit-and-loss diagram/graphic of these trades, where a profit is only achieved if the stock or index in question remains between a relatively narrow price range.  Outside of that range, profits quickly turn to losses.

Though far less common, reverse iron condors work in the exact opposite manner. That is, a loss is incurred of the underlying stock or index doesn't move out of a range, while the maximum profit is realized if the stock or index moves above the uppermost strike price or below the lowermost strike. Such trades are established by net-debit spread trades rather than net-credit spreads. In this case, the trader explicitly expects the stock or index in question to move considerably in the foreseeable future, but doesn't necessarily know which direction that instrument is poised to move.