Iron condor strategies involve combining two credit spreads or two debit spreads. While the strategies themselves are not complicated, managing the positions can be for option traders without the proper education. Iron condor strategies can be modeled out to be neutral or directional trades depending on the outlook. Trading iron condors can utilize your fundamental knowledge of the underlying or the technical and many times both. Let’s take a look at these fairly simple but often misunderstood strategies.
What Is a Long Iron Condor?
A long iron condor combines two vertical debit spreads: a call and a put spread. It is generally done in the anticipation of a directional move where one of the vertical debit spreads will profit more than the cost of both spreads. Generally, both vertical debit spreads are implemented out-of-the money (OTM) for a lower cost, which means more of a directional move may be needed to cover the risk. For example, let’s say a stock is at $50. An option trader is certain it will move but is unsure of the direction. He could buy a 40/45 bear put for 1.50 and a 55/60 bull call for 1.50 for a total of 3.00 (1.50 + 1.50). Maximum profit would be at $40 or below or $60 or above at expiration. The max profit would be the difference in the strikes ($5 in each case) minus the cost of 3.00 or 2.00 ($200 in real terms).
What Is a Short Iron Condor?
A short iron condor combines two vertical credit spreads: a call and put spread. The short iron condor is generally done in anticipation of a lack of a move at least between two levels. It is a credit position. Option traders are essentially combining two credit spreads as one trade. The trade is typically executed by buying a lower-strike OTM put and selling an OTM put with a higher strike (bull put). Then the trader sells an OTM call with a higher strike and buys another OTM call with an even higher strike (bear call). We will take a look at an example of a short iron condor below.
The Fundamentals of Iron Condors
Option traders who trade iron condors will often base the credit spreads off potential support and resistance levels. Many times, support and resistance have a better chance of keeping the underlying from moving through that level so it makes a valid argument. Some may use a certain delta, like 0.20 for example, knowing there is an 80% chance based on the definition of delt being the percentage the strike is expected to be in-the-money (ITM) at expiration. Still others may choose another form of technical analysis or fundamental analysis to base the spreads off. The trade is based on the possibility and the probability of the stock trading between both credit spreads especially if they are OTM by expiration.
Iron Condor Trading Example
Take a look at the chart below. It has been trading in a range for a couple of weeks now between about $130 and $138 to the upside.
Let’s say an option trader believes it will continue to trade within that range for another 10 days or so. Looking at the options, she can sell a 130 put for 1.80 and buy a 125 put for 0.70 with 10 days to go until expiration. At the same time, she can sell a 138 call for 1.50 and buy a 143 call for 0.70 with the same expiration as the puts. The total credit received and the max profit for the position is 1.90 ((1.80 – 0.70) + 1.50 – 0.70)) or $190 in real terms. This profit would be realized if the stock closed at $130 or higher and at $138 and lower at expiration.
The break-evens on this short iron condor are $128.10 (130 – 1.90) to the downside and $139.90 (138 + 1.90) to the upside. These are derived by subtracting the total credit received from the short put strike and adding the total credit received from the short call strike. The max loss is 3.10 (5 – 1.90). This is derived from the difference between the sold and bought strikes (5) minus the credit received. This would be realized if the stock is trading at or below the lower break-even ($128.10) and at or above the higher break-even ($139.90).
Lastly
Although the name may sound scary, an iron condor can be an option trader’s very close or even best friend. Like most options spreads, they are very versatile and fairly easy to understand with the proper education. Option traders need to stay disciplined and not make too many adjustments and dig themselves into a deeper hole than the original position.
John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.