Iron Condor Defined
An Iron Condor is an option spread trade constructed from two other separate spread trades - a bull put spread and a bear call spread.
Briefly:
- A bull put spread is a neutral to bullish trade. It's constructed by selling, or writing, a put at one strike price (presumably below the current share price) and then purchasing a second put at a lower strike price. Since the put you sell costs more than the put you buy, the transaction results in a net credit. This net premium income is your maximum gain and is yours to retain in full as long as the stock closes at or above the strike price of the initial put you sold. Since the put you purchased acts as a hedge, your maximum loss is the difference between the two strike prices (multiplied by 100 since each contract represents 100 shares of the underlying stock) less the net premium you originally received.
- A bear call spread is a neutral to bearish trade. It's constructed by selling, or writing, a call at one strike price (presumably above the current share price) and then purchasing a second call at a higher strike price. Since the call you sell costs more than the call you buy, the transaction results in a credit. This net premium income is your maximum gain and is yours to retain in full as long as the stock closes at or below the strike price of the initial call you sold. Since the call you purchased acts as a hedge, your maximum loss is the difference between the two strike prices (multiplied by 100 since each contract represents 100 shares of the underlying stock) less the net premium you originally received.
The iron condor combines these two trades, collecting net premium income from two sources instead of just one. In effect, the iron condor sets up a predetermined trading range with boundaries on both the upside and the downside. If the stock closes within that set range at the time of expiration, the maximum gain is achieved which, on a percentage basis based on the total amount of capital at risk, can be quite lucrative.
An Iron Condor Example
[note: for simplicity, commissions have been excluded from the example that follows.]
Suppose XYZ is trading at $35/share and you don't expect the stock to move much higher or lower in the near term. You choose to set up an iron condor spread trade where all options will expire in one month.
You simultaneously sell a $32.50 put for $1 and purchase a $30 put for $0.50. Since each contract represents 100 shares of underlying stock, that means you collect $50 in net premium. This constructs the bull put portion of the iron condor.
At the other end of the trade, you simultaneously sell a $37.50 call for $1 and purchase a $40 call for $0.50. Multiplying each contract by the 100 underlying shares which it represents, you collect an additional $50 in net premium. This constructs the bear call portion of the iron condor.
You have collected $100 in net premium. As long as XYZ closes anywhere between $32.50/share and $37.50/share, all options will expire worthless and you will achieve your maximum gain of $100
Your maximum loss occurs if the stock closes at expiration either at or below $30 (the maximum loss on the bull put portion) or at or above $40 (the maximum loss on the bear call portion). The maximum loss for the iron condor is the difference in the strike price of either the bull put or the bear call times 100 (per contract - the number of shares a contract represents) less the total amount of net premium received.
In the example above, the maximum loss equals $250 (the difference between the strike prices of either leg) less $100 in collected net premium, or $150 total. Even though you have two legs set up, because the stock can't close both above $40/share and below $30/share, the maximum loss is limited to the strike prices of only one leg.
Conclusion:
Iron condors can be a great way to earn high rates of return on range bound stocks. They are not without risk, however. An individual trader considering iron condors is advised to conduct additional research and consider all the risks involved before placing the trade.
