Learning the Iron Condor Option Strategy

by Evan

While I have been selling naked puts for a few years now, I haven’t really implemented any other options strategies on any kind of regular basis.  When I first learned about naked puts from a friend I dove head first into the topic, teaching myself about other strategies such as the bear/bull spreads, strangles, straddles and even the move that Madoff claimed he was using, the split strike.  I found the other strategies, besides the spread, weren’t really a good fit for me.  They each offered a complication and risk beyond what I was willing to take on the sale/short side (I have sued strangles and straddles on the buy side).

However, when that original friend who taught me about naked puts mentioned that I should at least look into the Iron Condor Strategy I figured it would be a good excuse to do some research and write a post.

How Does the Iron Condor Options Strategy Work?

According to the Options Guide,

The iron condor is a limited risk, non-directional option trading strategy that is designed to have a large probability of earning a small limited profit when the underlying security is perceived to have low volatility. The iron condor strategy can also be visualized as a combination of a bull put spread and a bear call spread. (Emphasis Added).

Iron Condor PictureSince there are two parts of the trade it may be beneficial to define each of the spread trades.

  • A Bull Put Spread is when you sell a put and buy a put with the same expiration date but lower strike price.  So your maximum profit and loss are predefined. The maximum profit is the net premium you take in from selling the put and buying the put.  Simultaneously you know your maximum loss on the trade since even if it the underlying company’s stock price tanks you have a protective put you can send the shares you were assigned.

I have sold bull put spreads in the past when there was frothy premiums available before an earnings call but I didn’t want the unlimited risk associated with naked puts.

  • A Bear Call Spread is when you sell a call and buy a call with the same expiration date but higher strike price.  Again, your maximum profit and loss are predefined.  The maximum profit is the net premium you take in from selling the call and buying the call; your maximum loss is high strike price minus the low strike price minus the premiums you took in.

An Iron Condor Example

The Options Guide provides a fantastic example:

Suppose XYZ stock is trading at $45 in June. An options trader executes an iron condor by buying a JUL 35 put for $50, writing a JUL 40 put for $100, writing another JUL 50 call for $100 and buying another JUL 55 call for $50. The net credit received when entering the trade is $100, which is also his maximum possible profit.

On expiration in July, XYZ stock is still trading at $45. All the 4 options expire worthless and the options trader gets to keep the entire credit received as profit. This is also his maximum possible profit.

If XYZ stock is instead trading at $35 on expiration, all the options except the JUL 40 put sold expire worthless. The JUL 40 put has an intrinsic value of $500. This option has to be bought back to exit the trade. Thus, subtracting his initial $100 credit received, the options trader suffers his maximum possible loss of $400. This maximum loss situation also occurs if the stock price had gone up to $55 instead.

To further see why $400 is the maximum possible loss, lets examine what happens when the stock price falls to $30 on expiration. At this price, both the JUL 35 put and the JUL 40 put options expire in-the-money. The long JUL 35 put has an intrinsic value of $500 while the short JUL 40 put is worth $1000. Selling the long put for $500, he still need $500 to buy back the short put. Subtracting the initial credit of $100 received, his loss is still $400.

From what I gather, the Iron Condor Options Strategy is basically a Strangle with a safety net built in to catch you if the stock tanks or takes off.

Will I be Implementing/Researching Iron Condors?

I can see why my friend suggested that I take a look at the strategy.  It provides two sources of income (from both spreads) rather than just one while providing a predetermined at risk amount.  Notwithstanding, I doubt I will implement the Iron Condor Strategy on the sell side.

On the short/sale/income side of the trade, I dislike that I have to worry about either direction of the stock.  My guess is that some would look the trade as a hedge, but that doesn’t make a lot of sense to me.  Currently, I am only worried about a tank of the stock (I am usually 10%+ out of strike price within 30 to 45 days), if I know had to worry about a pop of the stock as well, I think it would just cause me more stress.  It feels more like it would be easier to successfully play at Mobile Casino Kings.

I do, however, think, there is room for me to get back into bull put spreads.

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