Iron condors are a type of option strategy that combines put and call vertical spreads to provide options traders more flexibility. It helps to understand what iron condors are, how traders design them, and the possible risks and profits they offer to comprehend why they may appeal to certain investors.
On the same underlying stock, an iron condor is an options strategy that combines a bullish and bearish vertical spread. It thus consists of two call options (one long and one short) and two put options (one long and one short), all with the same expiration date but different strike prices.
The iron condor options strategy can be built as a long Iron Condor, with the trade generating a net negative, but it is more commonly used as a short Iron Condor, with the transaction generating a net credit from the start. The four options contracts together bring in more money than the investor must payout, resulting in a net credit.
If the underlying stock closes between the middle strike prices at expiry and all four options expire worthlessly, a short iron condor gets the most profit as a credit strategy.
The iron condor derives its name from the shape of the profit and loss graph it generates, which resembles a giant bird's body wings. The profit or loss diagram of a short iron condor is depicted in the graphic below.
The amount of premium, or credit, received for generating the four-leg options position is the maximum profit for an iron condor.
There is also a limit to the amount of money you can lose. The difference between the long call and short call strikes, or the long put and short put strikes, is the maximum loss. To calculate the overall loss for the trade, subtract the net credits earned from the loss and then add commissions.
If the price rises above the long call strike (which is higher than the sold call strike) or below the long put strike (which is lower than the sold outstrike), the maximum loss will occur.
An iron condor functions similarly to a strangle. A short strangle is a neutral strategy that gains when the stock stays between the short strikes over time, as well as when implied volatility falls.
It entails simultaneously selling a bullish spread (short put spread) and a bearish spread (short call spread). At expiration, the position profits if the stock falls between the strikes. Because the trade is a spread, the risk and reward are both known at the time of entry. The maximum potential profit is the credit earned for selling the position in advance.
The maximum loss is equal to the breadth of the largest spread (if spread widths are different). We are betting against the underlying moving past either spread by the expiration of our contracts because we are collecting a credit upfront and want our options to expire worthlessly.
A long iron condor, also known as a reverse iron condor, is a restricted risk options strategy entered for a net debit. When there is volatility and the price moves dramatically, either way, you can expect a profit. It's the polar opposite of a traditional iron condor, in which we receive a credit upfront and bet against the movement of a stock, with our strikes expiring out-of-the-money.
We pay a debit upfront with a reverse iron condor, and we need one of the spreads to move ITM at expiration in order to benefit by selling out of the spread for a higher value than we paid for it upfront.
A short iron condor spread is a four-part strategy that consists of a bull put spread and a bear call spread, with the short put strike price being lower than the short call strike price. The expiration date is the same for all selections.
The goal of a short iron condor trader is for the underlying stock to stay within the range set by the trade's inner strikes at expiration. This restricts the maximum profit to the amount of premium (or credit) gained for establishing the four-leg position. The difference between the long and short option strikes, minus the credit paid to open the trade, is the maximum loss.