What is the Iron Condor Options Strategy?
Iron condor is an options trading strategy that involves buying and selling four different options with the same expiration date. The strategy consists of two puts (one long and one short) and two calls (one long and one short), and four strike prices. The goal of the iron condor strategy is to profit from low volatility in the underlying asset. The maximum profit is earned when the underlying asset closes between the middle strike prices at expiration. The strategy has limited upside and downside risk, but also limited profit potential.
The iron condor strategy is a delta-neutral options strategy that profits the most when the underlying asset does not move much, although the strategy can be modified with a bullish or bearish bias.
Profit and loss of iron condor
The iron condor strategy has a limited profit potential and limited risk. The maximum profit is the net premium received while the maximum loss is the difference between the bought and sold call strikes and the bought and sold put strikes—less the net premium received.
The profit and loss areas of the iron condor strategy are well-defined. If the underlying asset closes between the two short strike prices at expiration, the full credit is realized as a profit. If the underlying asset price is above or below one of the long strike prices at expiration, the maximum loss will be realised.
Terms associated with iron condor options strategy
- Strike price: The predetermined price at which the options contracts are bought or sold. In the iron condor strategy, four different strike prices are typically involved: two for the call options and two for the put options.
- Spot price: The current market price of the underlying asset to which the options contracts are tied. It reflects the real-time value of the asset.
- Premium: The price paid by the trader to the seller of the option for entering into the options trade. It represents the cost of obtaining the rights or obligations associated with the options contract.
- In-the-money (ITM) call option: A call option is considered in-the-money when the spot price of the underlying asset is higher than the strike price. In the iron condor strategy, this would typically refer to the call options with the higher strike prices.
- Out-of-the-money (OTM) call option: A call option is considered out-of-the-money when the spot price of the underlying asset is lower than the strike price. In the context of the iron condor strategy, this often refers to the call options with the lower strike prices.
The iron condor option strategy: An example
Let us break down the strategy with an example:
Assumptions:
- Stock: ABC Ltd.
- Current stock price: Rs. 1,000
- Expiration date: 1 month from now
Steps in constructing an iron condor
1. Identify the range:
You believe that ABC Ltd. will remain relatively stable and trade within a specific range over the next month.
2. Select strikes:
You choose four different strike prices:
- Sell put (lower): Sell a put option with a strike price below the current stock price, for example, Rs. 950.
- Buy put (lower): Buy a put option with a lower strike price to limit potential losses, for example, Rs. 930.
- Sell call (higher): Sell a call option with a strike price above the current stock price, for example, Rs. 1,050.
- Buy call (higher): Buy a call option with a higher strike price to limit potential losses, for example, Rs. 1,070.
3. Execute trades:
- Put spread (Bull put spread):
- Sell 1 put option with a strike of Rs. 950.
- Buy 1 put option with a strike of Rs. 930.
- Call spread (Bear call spread):
- Sell 1 call option with a strike of Rs. 1,050.
- Buy 1 call option with a strike of Rs. 1,070.
4. Premiums:
You receive a premium for selling the put and call options. Let us say you receive Rs. 20 for each option, resulting in a total premium of Rs. 80.
5. Profit and loss scenario:
- Profit zone: If the stock price at expiration is between Rs. 950 and Rs. 1,050, you keep the premium received (Rs. 80 in this example).
- Loss zone: If the stock price goes below Rs. 930 or above Rs. 1,070, you start incurring losses. The maximum loss is capped at the difference in strike prices minus the premium received.
6. Manage the trade:
Monitor the trade and consider adjustments if the stock price approaches the breakeven points.
- Potential outcomes:
- Maximum profit: Rs. 80 (premium received).
- Maximum loss: Limited and determined by the width of the strikes minus the premium received.
Remember, the key to success with an iron condor is predicting that the underlying asset will remain within a specified range. It is important to continually monitor the trade and be prepared to adjust if necessary. Options trading involves risks, and it is advisable to have a good understanding of the strategy and potential outcomes before implementing it in the market.
Benefits of using iron condor strategy
- Profit in sideways markets:
The iron condor is designed to perform well in a sideways or range-bound market where the underlying asset's price remains relatively stable. Traders can capitalise on this type of market condition by earning premium income while the stock price stays within a specified range. - Known maximum profit and loss:
One of the significant advantages of the iron condor strategy is that traders know, in advance, both the maximum profit and the maximum loss they can incur. This transparency helps traders make informed decisions and manage their risk effectively. - Defined risk-reward ratio:
The strategy has a defined risk-reward ratio, which allows traders to assess the potential risk relative to the potential reward before entering the trade. This clarity is crucial for risk management and aligning the strategy with the trader's risk tolerance. - Flexibility in adjustment:
The iron condor is a flexible strategy that can be adjusted and managed during the life of the trade. If the market conditions change or there are indications that the price may breach one of the breakeven points, traders have the option to adjust to limit potential losses or enhance potential gains. - Income generation:
By selling both a put spread and a call spread, traders receive premium income upfront. This premium is the maximum profit the trader can achieve, and it is received regardless of whether the options expire worthless or are exercised.
Conclusion
It is important for traders to fully understand the risks and complexities of the iron condor strategy and to actively manage the trade throughout its duration. While it offers benefits in certain market conditions, no strategy is without risks, and market dynamics can change. Regular monitoring and adjustment are key components of successful iron condor trading.
