What is an Iron Condor
An iron condor is a short options strategy created with four options consisting of two puts and two calls, and four strike prices, all with the same expiration date. Its goal is to profit from low volatility in the underlying asset. In other words, it earns the maximum profit when the underlying asset closes between the middle strike prices at expiration.
The strategy has limited upside and downside risk because the high and low strike options, the wings, protect against significant moves in either direction. Because of this limited risk, its profit potential is also limited. The commission can be a notable factor here, as there are four options involved.
BREAKING DOWN Iron Condor
An iron condor is similar to an iron butterfly because they profit from the same conditions in the underlying asset. The major difference is the maximum profit zone, or sweet spot, for a condor is much wider than that for a butterfly, although the tradeoff is a lower profit potential. Both strategies use four options.
For this combination strategy, the trader ideally would like all of the options to expire worthlessly, which is only possible if the underlying asset closes between the middle two strike prices at expiration. There will likely be a fee to close the trade if it is successful. If it is not successful, the loss is still limited.
The construction of the strategy is as follows:
- Buy one out-of-the-money put with a strike price below the current price of the underlying asset. The out-of-the-money put option will protect against a significant downside move to the underlying asset.
- Sell one at-the-money put with a strike price closer to the current cost of the underlying asset.
- Sell one at-the-money call having a strike price just above the current price of the underlying asset.
- Buy one out-of-the-money call with a strike price further above the current price of the underlying asset. The out-of-the-money call option will protect against a substantial upside move.
The out-of-the-money options, called the wings, are both long positions. Because both of these options are out-of-the-money, their premiums are lower than the two at-the-money options written, so there is a net credit to the account when placing the trade. Further, by selecting different strike prices, it is possible to make the strategy lean bullish or bearish. For example, if the middle strike price is above the current price of the underlying asset, the trader hopes for a small rise in its price by expiration. It still has limited reward and limited risk.
Deconstructing the Condor
Two different option combinations will produce the same results. The first version is as a combination of a bull put spread and a bear call spread. Unlike an iron butterfly, the strike price of the bull put, the higher option, and the bear call, the lower option, are not the same.
Alternatively, the two at-the-money options start with a short straddle, which involves selling a put and a call with the same at-the-money strike and expiration. It then adds a long strangle, to create the wings, buying both the out-of-the-money call and put.