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.
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Iron Condor Construction
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Sell 1 OTM Put
Buy 1 OTM Put (Lower Strike) Sell 1 OTM Call Buy 1 OTM Call (Higher Strike) |
Using options expiring on the same expiration
month, the option trader creates an iron condor by selling a lower strike out-of-the-money put, buying an
even lower strike out-of-the-money put, selling a higher strike out-of-the-money call and buying another even higher strike
out-of-the-money call. This results in a net credit to put on the trade.
Limited Profit
Maximum gain for the iron condor strategy is
equal to the net credit received when entering the trade. Maximum profit is
attained when the underlying stock price at expiration is between the strikes
of the call and put sold. At this price, all the options expire worthless.
The formula for calculating maximum profit is
given below:
- Max Profit
= Net Premium Received - Commissions Paid
- Max Profit
Achieved When Price of Underlying is in between Strike Prices of the Short
Put and the Short Call
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Iron Condor Payoff Diagram
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Limited Risk
Maximum loss for the iron condor spread is also
limited but significantly higher than the maximum profit. It occurs when the
stock price falls at or below the lower strike of the put purchased or rise
above or equal to the higher strike of the call purchased. In either situation,
maximum loss is equal to the difference in strike between the calls (or puts)
minus the net credit received when entering the trade.
The formula for calculating maximum loss is
given below:
- Max Loss =
Strike Price of Long Call - Strike Price of Short Call - Net Premium
Received + Commissions Paid
- Max Loss
Occurs When Price of Underlying >= Strike Price of Long Call OR Price
of Underlying <= Strike Price of Long Put
Breakeven Point(s)
There are 2 break-even points for the iron
condor position. The breakeven points can be calculated using the following
formulae.
- Upper
Breakeven Point = Strike Price of Short Call + Net Premium Received
- Lower
Breakeven Point = Strike Price of Short Put - Net Premium Received
Example
Suppose XYZ stock is trading at Rs45 in June. An
options trader executes an iron condor by buying a JUL 35 put for Rs50, writing
a JUL 40 put for Rs100, writing another JUL 50 call for Rs100 and buying
another JUL 55 call for Rs50. The net credit received when entering the trade
is Rs100, which is also his maximum possible profit.
On expiration in July, XYZ stock is still
trading at Rs45. 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 Rs35 on
expiration, all the options except the JUL 40 put sold expire worthless. The
JUL 40 put has an intrinsic value of Rs500. This option has to be bought back
to exit the trade. Thus, subtracting his initial Rs100 credit received, the
options trader suffers his maximum possible loss of Rs400. This maximum loss
situation also occurs if the stock price had gone up to Rs55 instead.
To further see why Rs400 is the maximum possible
loss, lets examine what happens when the stock price falls to Rs30 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 Rs500 while
the short JUL 40 put is worth Rs1000. Selling the long put for Rs500, he still
need Rs500 to buy back the short put. Subtracting the initial credit of Rs100
received, his loss is still Rs400.
Disclosure/Disclaimer and FAQ
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