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Published On: Sat, Nov 10th, 2012

The Iron Condor Spread

There is little doubt that among beginner options traders the iron condor spread is one of the most popular. The ability of this trading strategy to profit from markets that are trading within a reasonably narrow range has in fact become legendary.

What is an iron condor?

An iron condor is a neutral advanced options trading strategy consisting of the following elements:

  1. x number of OTM short call options
  2. x number of OTM short put options
  3. x number of far OTM long call options and
  4. x number of far OTM long put options

One therefore enters an Iron Condor spread by selling OTM call and put options and buying the same number of further OTM call and put options for the same instrument and expiration date.

Fig. 9.05(d) shows what a typical Iron Condor looks like.

Fig. 9.05(d)

Credit spread

An iron condor is a credit spread, which means the trader does not have to pay anything up front to enter the trade. Having said that, the trade involves margin, so the trader will have to meet his or her broker’s margin requirements. Beginner stock options traders will usually not be allowed to enter into iron condor trades by their brokers, although with FX options there is normally no such limitations as long as the margin requirements can be met.

Maximum profit of an iron condor

The maximum profit a trader stands to make from an iron condor trade is equal to:

  1. The premium received from writing the short options.
  2. Minus the premium paid for the long options.
  3. Minus the commission on the trade.

Maximum loss

The Iron Condor differs from a short strangle in the respect that it does not have unlimited loss. This is because an Iron Condor in fact consists of a short strangle combined with a further OTM long strangle which limits the maximum loss.

The maximum loss of an Iron Condor is limited to the difference between the strike prices of the long options and the short options minus the net premium received when entering the trade.

Breakeven point

There is a direct link between the strike prices of the short options and the breakeven points of the iron condor. In fact, the upper breakeven point is equal to the strike price of the short call options plus the net credit received (the difference between premiums received and paid).

Conversely, the bottom breakeven point is equal to the strike price of the short put options minus the net credit received.

Profit/loss ratios

It has to be mentioned that, although the iron condor has limited risk, the maximum loss is still larger than the maximum profit, as can be seen from our hypothetical example in Fig. 9.05(d).

This is counterbalanced by the fact that the trader sells OTM options with a low probability of expiring in the money, i.e. the trade has a relatively high probability of being profitable.

Conclusion

As always with options trading, the iron condor is a trade-off between risk, potential profit and the probability of actually making that profit. It has a lower reward/risk ratio than an Iron Butterfly, but it also has a higher probability of actually being profitable. Conversely, it carries lower risks than a similar short strangle, but if profitable it will make less money than the short strangle, because the long options involved cost money.

 

 

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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