The Iron Condor Options Strategy: Methods, Pros and Cons, and Examples
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Summary:
The iron condor options strategy is a popular approach among traders due to its limited risk and the potential for a maximum profit that is equal to the premium received. With the iron condor, traders purchase and sell two puts and two calls, each with a different strike price but the same expiration date. The goal is for the underlying asset to close between the middle two strike prices at expiration, which maximizes the profit potential. There are still fees involved, but the commission can be significant given the four options involved in the strategy. Despite these risks, the iron condor can be a profitable approach for those looking to capitalize on low volatility in the market.
The iron condor options strategy involves buying and selling two puts and two calls, each with a different strike price but the same expiration date. The sweet spot for earning maximum profit is when the underlying asset closes between the middle strike prices. The strategy aims to capitalize on low volatility.
The iron condor is similar to a regular condor spread but uses both calls and puts instead of only one type. It’s also an extension of the butterfly spread and iron butterfly strategies.
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Overview of the iron condor trading strategy
Let’s look at how the iron condor strategy works. With limited upside and downside risk, the iron condor is a popular options strategy among traders today. The two outer strike options, known as “wings,” provide protection against significant moves in either direction. While this limits the profit potential, it also limits the risk involved.
The goal of the iron condor strategy is to have all of the options expire worthlessly, which is only possible if the underlying asset closes between the middle two strike prices at expiration. However, if the trade is successful, there may still be a fee to close it. On the other hand, if the trade is not successful, the loss is still limited.
What do ATM and OTM mean in options trading?
Before we dig into how the iron condor option strategy works, you need to understand two key term in options trading, “to be out of the money” or OTM, and “to at the money” or ATM. We say an option is”out of the money” (OTM) when the current market price of the underlying asset is below the strike price for a call option or above the strike price for a put option. On the other hand, you are “at the money” when an option’s strike price is the same as the current market price of the security. Call and put options can both be simultaneously “at the money” or ATM.
It’s important for investors to remember that the commission can be a notable factor, as there are four option orders involved in the strategy.
The 4 steps of the iron condor option strategy
To construct an iron condor, traders need to
1. Purchase one OTM put option below the underlying asset price to protect against a significant downside move.
2. Sell one OTM or ATM put option closer to the underlying asset price.
3. Sell one OTM or ATM call option above the underlying asset price.
4. Purchase one OTM call option above the underlying asset price to protect against a substantial upside move.
2. Sell one OTM or ATM put option closer to the underlying asset price.
3. Sell one OTM or ATM call option above the underlying asset price.
4. Purchase one OTM call option above the underlying asset price to protect against a substantial upside move.
Both wings in the iron condor are long positions, and they have lower premiums than the two written options, resulting in a net credit to the account when initiating the trade.
Different strike prices can be chosen to make the strategy bullish or bearish. For instance, if both middle strikes are above the current asset price, the trader expects a slight rise in price by expiration. Nevertheless, the trade has limited risk and limited reward.
The iron condor strategy profits vs. losses
The iron condor’s maximum profit is the premium received for the position. The maximum loss is capped and determined by the difference between the long and short strikes of the calls or puts.
To calculate the total loss, subtract the net credits received and add commissions. The maximum loss happens when the price goes beyond the long call or put strike, exceeding the sold call or put strike.
Iron condor example
An investor believes that Apple Inc. will remain flat in price over the next two months and decides to implement an iron condor with the stock trading at $212.26. They sell a call option with a $215 strike for a $7.63 premium and buy a call option with a $220 strike for a $5.35 cost. They also sell a put option with a $210 strike for a $7.20 premium and buy a put option with a $205 strike for a $5.52 cost.
The total credit for the position is $3.96, or $396. This is the maximum profit that can be made if the price remains between $215 and $210 at expiration, but a reduced profit can still be made if the price moves outside of this range.
The maximum loss occurs if the price trades above $220 or below $205. If the stock expires at $225, the trader faces a loss of $104 plus commissions, and if it expires at $208, the trader makes $196, with fewer commission costs.
How profitable is the iron condor options strategy
Iron condors can be profitable when the closing price of the underlying asset is between the middle strike prices at expiration and when there is low volatility in the asset. For example, a short iron condor can be created by combining a 75-80 bull put spread with a 95-100 bear call spread, resulting in a difference of 15 points for the strike price of the short options and five points for both spreads.
How risk affects options strategies
Iron condors have risks, including the possibility of the price of the underlying asset moving outside the strike prices, there are even riskier options strategies. Selling call options on a stock that is not owned, also known as writing a naked call, is considered the riskiest option strategy.
If the price of the stock goes above the strike price, the seller of the option must buy the stock at the market price and sell it at the lower strike price, resulting in unlimited risk if the price of the stock continues to rise.
Key takeaways
- The iron condor is an options strategy that can be modified with a bullish or bearish bias, and profits when the underlying asset does not move much.
- It consists of four options of the same expiration: a long OTM put and a short ATM put, and a long OTM call and a short ATM call.
- The maximum profit is limited to the premium received, while the maximum loss is limited to the difference between the bought and sold strikes, less the net premium received.
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Allan Du is a personal finance writer passionate about helping people take control of their finances. Allan strives to present readers with the right knowledge and tools, so they can make informed decisions about their money and build wealth. When he is not writing about finance, Allan enjoys pursuing his other interests, including powerlifting, kickboxing, and investing. He is an active follower of economic and political trends, always keeping watch on the latest developments that could impact the financial world.
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