What is Iron Condor Strategy and How to Use it?

Iron condors are an example of an option strategy that uses put-and-call verticals and spreads to create flexible opportunities for options traders. Trading stock options has grown in popularity among seasoned and private investors. You may be familiar with the fundamental idea that, rather than buying stocks, you can use options to bet on the future direction and magnitude of stock price movement. If your prediction is correct, you benefit from the agreement. If you do, you lose.

Similarly, you can implement various sophisticated options trading techniques depending on the volatility and upward or downward movement you anticipate for a given stock or index. Iron condors are non-directional or market-neutral, implying that you can make money off of them regardless of which way the underlying stock or index goes. A decrease in volatility, time decay, and little to no change in the underlying asset are all factors that the iron condor approach attempts to capitalize on. Iron condors are essentially short-strangled with long option protection acquired above and below the short strikes to define risk. Continue reading to find out how iron condors operate, when trading them can be profitable while limiting risk, when to utilize them, and the origin of the name "iron condor."

What is an Iron Condor?

An iron condor is an options strategy comprising four strike prices, 2 puts (one is long and other one is one short), and two calls (one long and one short), each with the same expiration date. The iron condor generates the maximum monetary benefit whenever the underlying asset closes between the intermediate strike prices at expiration. In other words, the objective would be to profit from the underlying asset's low volatility. The iron condor involves both puts and calls, contrary to just calls or just puts, and delivers a reward similar to that of a typical condor spread. The premium paid establishes a limit on the possible profit, while the difference between call and put strike prices, less the net premium paid sets a limit on the potential loss. The butterfly spread and iron butterfly are extensions of the condor, also known as the iron condor.

An options trader that uses the non-directional Iron Condor technique combines a bull put spread, and a bear call spread to profit. This method has a high probability of yielding profit. This technique is mainly used when an option trader thinks the market range will be bound. The maximum gain in an iron condor strategy is equal to the net premium received after commissions. The maximum loss happens when the underlying security price is greater than the strike price of the long call or lower than the strike price of the long put.

Understanding the Iron Condor Strategy

The iron condor strategy's upside and downside risks are kept to a minimum mainly due to the wings' high and low strike options, which protect against significant moves in either direction. Thus, its profit potential is constrained by the limited risk. In this strategy, the trader's intended result for this technique is for all options to expire worthlessly, which happens only if the underlying asset closed at a price between the middle two strike prices at expiry. An emolument will probably be charged nearby if the trade is profitable. That way, the loss is still minimal, even if it fails. The iron condor strategy is prepared as follows:

• Purchase a put with an out-of-the-money (OTM) strike price lower than the current value of the underlying asset. This OTM put option will shield you from a substantial decline in the value of the underlying asset.

• Dispose of one OTM or at-the-money (ATM) put with a strike price closer to the underlying asset's current value.

• One ATM or OTM call with a strike price higher than the current value of the underlying asset should be sold.

• Purchase one OTM call with a strike price higher than the underlying asset's current price. This OTM call option will protect a significant upward movement.

The options that are additionally OTM, known as "wings," are both in the extended position. It has a net credit to the account when setting down the trade because both options are further out-of-the-money and have lower premiums than the two written options.

It will help to make the strategy lean bullish or bearish by choosing various strike prices. The trader anticipates a slight increase in the underlying asset's price by expiration, for instance, if both of the middle strike prices are higher than the asset's current value on, for example, if both of the middle strike prices are higher than the asset's current value. In any case, the trade still has a small potential upside and a slight potential downside.

How Does the Iron Condor Function?

Many options traders work in terms of the iron condor strategy with the hope of earning a profit. An investor can also lose money, which shows the negative side of trading. Learn about the workings of the iron condor beforehand to determine the market and shield yourself from potential losses. To build the iron condor, work according to the following points:

Firstly, choose an expiration date. Although you can theoretically choose any period until expiration, Kaufman advocates balancing this decision with your capacity to handle the trade. "That implies selecting an expiration date that is between 30 and 50 days away."

Choose to call and put the option on sale: According to Kaufman, one strategy is to consider the option's delta. The probability that a prospect will expire in the money (ITM) or be profitable is calculated using the term "delta." The likelihood of the call and put expiring in the money (ITM) ranges between 15% and 20%. Suppose you choose a call and set a strike with a delta of 0.15 to 0.20. Adhering to that criteria gives you a 60% to 70% chance of making the maximum profit by expiration.

Purchasing at the strike price: Lastly, choose which strikes to buy as a security against a significant price change. Kaufman advises being careful: "Select a call and put a strike price that is a strike or two more out of the money (OTM)." For most equities, the typical strike width between the long and short strikes is $2.

Although it may seem refutable, an iron condor is most profitable when all four options expire out of the money. Your losses may increase if one side or another expires ahead of schedule.

Profits and Risks of the Iron Condor

The iron condor is referred to as a neutral strategy. The trader can make money whether the underlying asset goes up, down, or trades sideways. The trader is weighing the likelihood of success against the potential loss. Thus, the possible return on this investment is typically substantially lower than the amount at risk. The amount of premium, or credit, received for constructing the four-legged option position indicates the iron condor's maximum profit.

Even though the profit is limited to the premium paid, iron condors can be beneficial. While range-bound movement in the stock price is necessary for iron condors, the strikes expire worthlessly and at a maximum profit if they are OTM at expiration. Learn more about the profitability of the iron condor. Because you may reduce your risk and don't require an underlying to move anywhere, an iron condor is seen as a method that can increase your chance of success. Selling an iron condor is a high-probability trading technique, and when we sell spreads far out of the money, the chance of making money is often greater than 50%.

Risks of the Iron Condor

The best-known option strategy in the book is probably the iron condor. But frequently, traders lose money and go into difficulty. There are many risks involved while implementing the iron condor strategy. It is important to stay vigilant and protect yourself from possible damage. The main risks involved are the following:

Risk 1: Adequate Market Circumstances

An iron condor is very reliant on the market circumstances at the time of the deal, unlike some other techniques. The best time to enter an iron condor is when the stock is likely to remain in a trading range, which increases the likelihood of success.

Risk 2: Black Swan Events

Markets are thought to be quite efficient, with the majority of information already "priced in."This indicates that stock prices are generally fair and represent all available information. Black swans do, however, occur frequently during our lives.

A black swan is a major but unusual or shocking event with numerous unanticipated effects. An illustration of a black swan occurrence is the recent COVID-19 pandemic of 2020. Investors are faced with many unknowns when black swan occurrences occur, which causes a large variation in how information is "priced in."

As a result, markets may experience significant swings as investors struggle to comprehend the new normal for the economy and the markets. Black swan occurrences may present the biggest danger when trading iron condors because of the exceptionally high volatility that is frequently felt both before and after them.

Risk 3: The Call Side

The side of an iron condor where you often lose the most money is the call side.

This is because most traders naturally want to safeguard their assets. Since most investors will have long positions in stocks, they will use put options, which increase in value as equities fall, to protect their portfolio from losses.

When you initiate your position, purchasing these put options raises prices, causing skew and a negative delta (the call spread will be closer to at-the-money).

Legging into your position, which involves starting with your put spreads and executing your call spreads at a favorable period, is one strategy to reduce this risk. Another option is to trade fewer call spreads than put spreads.

Risk 4: Earnings Events

Iron condor trading is frequently done by new traders using earnings events. The issue is that because they are binary events, you can only be correct or wrong at one particular moment. You have several opportunities to manage your position when trading in typical market conditions, constantly re-evaluating and adjusting to increase your chances of success. You are unable to manage your position when you trade an iron condor over an earnings event; as a result, you either wake up a winner or a loser the following day. Trading an iron condor over an earnings event prevents you from being able to control your position; as a result, you either wake up a winner or a loser the following day, so you had better be confident that you know more than the bulk of the market. Avoiding trading earnings announcements is the easiest approach to reducing this risk.

How to Use an Iron Condor in Options Trading

When using this tactic, there are many considerations. To begin with, stick to index selections. They offer just enough implied volatility to generate a nice return, but they lack the true volatility that can quickly drain your account. You must never take a full loss on an iron condor. Your chance of losing money is substantially bigger than your chance of winning it. It is higher than 80% on each sides (it is possible using delta as a probability indicator. that the market will not close beyond those strike prices). If the market behaves like it usually does and trades in a range, you don't need to take any action and can simply let the entire position expire worthlessly. Your complete credit is yours to keep in this situation. You must, however, exit that side of the position if the market moves strongly in one direction or the other and approaches or breaks through one of your strikes.

How to Avoid a Bumpy Landing

There are numerous ways to exit the iron condor's one side. One is to merely sell one-half of that specific credit spread while holding the other. Another option is to remove the entire iron condor. Depending on how much time is remaining until the expiration, this will change. The losing side may also be rolled over to a subsequent out-of-the-money strike. There are numerous potential outcomes in this situation, and risk management is where the iron condor's true talent rests. You must have a strategy that puts probability, option time premium selling, and implied volatility on your side if you do well on this side.

Examples of How to Use an Iron Condor

Assume a potential investor thinks Apple Inc.'s pricing will remain largely stable over the next two months. With the stock currently trading at $212.26, they opt to employ an "iron condor."

They receive a premium of $7.63 when they sell a call with a $215 strike price and pay $5.35 to buy a call with a $220 strike price. Each option contract, whether a put or a call, represents 100 shares of the underlying asset, and the credit on these two is $2.28, or $228 for a single contract. But the deal is only halfway done. The trader also buys a put with a strike price of $205 for $5.52 and sells a put with a strike price of $210, earning a premium of $7.20. $1.68 would be the net credit on these two legs, or $168 if one contract were traded on each.

The position is worth $3.96 ($2.28 + $1.68), which is equal to $396. The trader can earn up to this amount of money if all of the options expire worthless, which necessitates that the price is between $215 and $210 when expiry happens in two months. The trader may still make a profit, but it would be smaller if the price were above $215 or below $210.If the price of Apple stock drops below the lower put strike ($205) or the upper call strike ($220), the loss increases. The largest loss happens if the stock price fluctuates between $220 and $205.

Suppose the stock is worth $225 when it expires. Since this is above the higher call strike price, the trader is exposed to the greatest loss imaginable. The purchased call profits $5 ($225 - $220), while the sold call loses $10 ($225 - $215). Puts are lost. The trader made $396 in premiums in addition to losing $5, for a total loss of $500 (100 share contracts). As a result, the maximum loss is $104 plus commissions. Consider instead that Apple's price fell, but not below the lower put level. It has dropped to $208 now. In comparison to the long put, which expires worthless, the short put loses $2 ($208 - $210), or $200.Additionally, the calls end. While holding the position, the trader incurs a $200 loss but gains $396 in premium credits. As a result, after deducting commission fees, they still make $196.

Final Thoughts

Experienced traders with extensive market experience are ideally suited for the iron condor option strategy. It is one of the finest ways for an option trader to benefit from a small variation in the price of an underlying asset. It functions best if you wish to optimize your profits while anticipating less fluctuation. Many traders think that to turn a profit; there must be a major move, either higher or lower. However, as you've learned from the aforementioned approach, traders can make good money when the asset's price isn't directional. Finding the two inner strike prices that lie between the two big strike prices is the key to this method. This is where this tactic works best. Iron condors can generate substantial profits, but there is a risk involved. Don't let the strategy's complex structure deter you from learning more about this effective trading technique. It may initially seem confusing, which is why experienced traders employ it more frequently. We sincerely hope you found this blog interesting and will take advantage of its practical applications and prevent yourself from potential risks at the same time. Share this blog with your family and friends to further our goal of promoting financial literacy and to show your support as well.

Trade safe!