Iron Condor Basics
An Option Strategy for Market-Neutral Traders
Iron Condor Basics
1) The iron condor is a position with four legs ( four different options) constructed by selling one put spread and one call spread (simultaneously by using a spread order) with the following restrictions:
- All four options are on the same underlying asset
- All four options expire at the same time
- Although not a strict requirement, all options are out of the money when the trade is initiated
- The iron condor contains an equal quantity of each of the four options
- The call spread and the put spread have the same spread width. Translation: The two calls are as far apart from each other as are the two puts. NOTE: It does not matter how far apart the calls are from the puts.
NOTE: When the call spread and put spread are sold, the trader collects a cash premium. That cash represents the maximum possible profit for the trade.
NOMENCLATURE: We sell the call spread and sell the put spread to create an iron condor. Some references call this "selling the iron condor" while others refer to this as "buying the iron condor." Do not get confused. All you have to do is know which language your broker uses so that you can enter orders correctly. By being certain that you collect a cash credit when initiating the iron condor position, it does not matter how your broker chooses to name the trade.
EXAMPLE. This is NOT a recommended trade; it is merely an example.
SPY is trading near $200 per share.
Buy 2 SPY Sep 16 '16 203 calls
Sell 2 SPY Sep 16 '16 202 calls
Buy 2 SPY Sep 16 '16 197 puts
Sell 2 SPY Sep 16 '16 198 puts
In the above example, the iron condor has these characteristics:
- SPY as the underlying asset
- Option expiration is Friday, Sep 16, 2016
- Two call spreads and two put spreads are sold. Note: The spreads have been sold, and not bought, because the more expensive option has been sold and a less expensive (farther out of the money) option has been bought.
- All four options are out of the money (OTM)
- The call spread is 1-point wide (203 minus 202 = 1)
- The put spread is 1-point wide (198 minus 197 = 1)
2) The iron condor is an option strategy that earns money as time passes -- as long as the underlying asset price does not threaten to move out of a predetermined price range. In this example, that range is 198 to 202. The range is bordered by the two options that were sold (202 call and 198 put).
As time passes, all the out-of-the-money options lose value -- unless the underlying asset's price moves closer to the strike price of the option. Thus, you can consider an iron condor position to be a race:
Will the options that you sold move into the money, or will they expire worthless?
Prudent iron condor traders do not wait for one or the other to happen. They manage risk during the holding period.
The iron condor is an option strategy that loses money when the underlying stock moves out of -- or threatens to move out of -- a predetermined price range. Thus, it is an appropriate strategy for traders whose market bias is neutral. In other words, the trader does not expect to see a bullish or bearish market during the lifetime of the options.
3) The iron condor is a hedged, limited-loss position.
It is important to understand the following:
When owning this iron condor position, the trader believes that SPY will neither approach, nor move higher than, $202 during the lifetime of the options.
Nevertheless, the trader buys the 203 call -- not because he/she believes that the stock price will rise that high, but to limit losses, just in case the market does move that high. Thus, the 203-call is bought as a hedge.
When owning this iron condor position, the trader believes that SPY will neither approach, nor move lower than, $198 during the holding period.
Nevertheless, the trader buys the 197 put as a risk-limiting hedge.
4. The iron condor should be considered as a single position. The objective is to trade the iron condor to earn a profit. There are two ways to achieve that profit:
- Allow all four options to expire worthless. When that happens the trader's profit is the cash collected at the time the initial trade was made.
- Buy (to close) both spreads When the price paid is less than the premium collected, the trader earns a profit. If the cost to exit the position is greater than the initial premium collected, then the trader loses money.
There is much more to learn about trading iron condors (one example). This article is intended to be a starting point that describes the strategy.