Iron Condor

The Iron Condor Setup

Let’s take a stock, JKL Corp, that is trading at $100. To set up an Iron Condor, you would sell the following:

• Put option with a strike price of $95 for $2
• Buy a put option with a strike price of $90 for $1
• Sell a call option with a strike price of $105 for $2
• Buy a call option with a strike price of $110 for $1.

All options have the same expiration date, say three months from now.

Who Should Consider It

This strategy is suitable for those traders who believe the stock price will have low volatility, and it might not move out from its relatively narrow range near its current level. The solution is particularly tempting in low market volatility periods since premium incomes are generated with relatively lower risk.

Strategy Explained

In an Iron Condor, the sold options-the put and the call at $95 and $105-will bring in the premium, and the bought options-the put and the call at $90 and $110-will limit the potential losses. It is hoped that the stock price does not move between the strikes of the sold options so that all options will be worthless when they expire and the premium is retained.

Breakeven Procedure

There are two breakeven points for an Iron Condor:

• Upper breakeven: Strike price of the sold call + net premium received.
• Lower breakeven: Strike price of the sold put - net premium received.

In this example, the net premium received is $2 ($2 + $2 - $1 - $1), making the breakeven points $97 ($95 + $2) and $103 ($105 - $2).

Sweet Spot

The sweet spot for this strategy comes when the stock price at expiration is somewhere between the two middle strike prices $95 and $105 in this example. Here the maximum profit potential is realized because all the options expire worthless.

Max Profit Potential

The maximum profit of an Iron Condor is equivalent to the net premium received from the sold options minus the premium paid for the bought options. In this example, that’s $2 per share.

Max Loss

The maximum loss is incurred if the stock price moves significantly beyond either the highest or lowest strike prices. It is capped at the difference between the strikes of the bought and sold options minus the net premium received. Here, it would be $5 ($100 - $95 or $110 - $105) minus $2, so a maximum loss of $3 per share.

Risk

The main risk is that the stock price moves out of the preferred range, hits either the upper or lower breakeven points, and there is a potential total loss of the premium paid.

Time Decay

This strategy benefits from time decay, theta. Since this is a net short options strategy, the value of the options decreases with the passage of time, which is beneficial as long as the stock price remains between the breakeven points.

Implied Volatility

This strategy has a critical influence of implied volatility. Lowered volatility is a positive since it reduces the stock price’s likelihood of hitting the breakeven points. Conversely, an increase in volatility is adverse since it increases the stock’s likelihood of exiting the profitable range.

Conclusion

An Iron Condor is a great strategy for taking advantage of stability in a stock or index. It has defined risk and reward parameters, which makes it the favorite of traders who want to profit from sideways market movements and the decay of time value in options.