Iron condors provide advanced traders with consistent small returns
Generally speaking, volatility has been relatively high in the last decade. So when it comes to iron condors and other options strategies sensitive to volatility, we often see them trade at a discount. As volatility increases or decreases, the value of iron condor changes — sometimes significantly.
An iron condor is a strategy designed to have a substantial probability of earning a little profit when the underlying security is perceived to have low volatility. This means the investor doesn't have to view whether the market will go up or down; they only need to identify a range where they believe the stock price will be by the expiration of the options contract.
The option strategy involves the simultaneous purchase and sale of either out-of-the-money (OTM) calls or puts of the same underlying security and expiration date. That's why it's considered a "condor" because, with four different strikes, it looks like a bird with wings spread out getting ready to fly. We will look at an example below using a call iron condor. A put iron condor would be structured the same way using puts instead of calls.
High volatility makes an iron condor more expensive because there's a greater possibility that the underlying stock will move outside the range you set for your iron condor trade. In this case, you could either close out your position early and accept a loss or hold on until expiration and suffer potentially much more significant losses.
This article will discuss the iron condor options strategy and its advantages.
What is the Iron Condor Options Strategy?
To implement this strategy, the investor needs to buy an out-of-the-money call option and sell an out-of-the-money call option of a higher strike with the same expiration. At the same time, they also need to buy an out-of-the-money put option and sell an out-of-the-money put option of a lower strike with the same end.
You believe that the S&P 500 Index (SPX) will trade in a range for the next several weeks. You think this because it has recently been trading in a narrow range, with relatively low volatility. You expect the range trading to continue until some significant catalyst emerges to create a breakout from the range.
This belief can lead to a strategy that profits from SPX staying within a defined range. Specifically, you could sell an iron condor. The iron condor trader expects the underlying to remain within a specified range until expiration. The maximum gain is limited and occurs when the underlying stays above the long puts, a lower strike, and a higher strike at the end below the long calls. The loss is limited to the difference between strike prices, less premium for placing on trade, or debit paid for putting on a business.
The strategy involves selling two options contracts (puts and calls) with different strike prices but with the same expiration date. The strike prices of the options should also be equidistant from the current price of the underlying stock (i.e., both options are at the money). When this happens, both contracts expire worthlessly, and you keep the total credit you received for entering the trade.
The maximum profit is achieved if the underlying security closes at or near the strike price of the short option at expiration. The maximum loss equals the premium paid for both spreads (the distance between strikes minus the net credit received). The breakeven points are located at the lower and upper strikes plus/minus the net debit paid for both spreads.
A trader can adjust the iron condor by rolling one or both spreads to different strikes before expiration. A trader may move this strategy up or down depending on where you think the underlying security will trade from expiration to expiration.
If you think volatility will increase, roll your short spread away from market value (further OTM). If you think volatility will decrease, move your short spread closer to market value (ITM).
What Are the Advantages of the Iron Condor Options Strategy?
It is a 4-legged options strategy. An iron condor consists of two vertical spreads – a bull put spread and a bear call spread. It is defined as a risk instead of an undefined risk (such as writing naked options) and provides a perfect reward to risk ratio.
The maximum risk that a trader can incur is the difference in strike prices of the short strikes, less the net credit received. The total profit potential of an iron condor is the credit received when entering the trade. We collected $0.30 per share or $30 per contract in our example above.
The key idea behind the strategy is that you're selling two options contracts on one side of the spread (either above or below the current price of the underlying security) and buying two options contracts on the other side of the spread (either above or below). Both sides of the spread are equidistant from each other and equidistant from where you expect the stock's price to end at expiration. This results in one leg being profitable (the sold leg) while you hold the risk on the other leg (the bought leg).
When Should You Use the Iron Condor Options Strategy?
This strategy involves selling a put and buying another put at a lower strike price in the same month and simultaneously selling a call and buying another call at a higher strike price in the same month. All options have the same expiration date. The sale of the higher strike call and lower strike put help pay for the cost of buying the more downward strike put and higher strike call, resulting in a net credit received when entering the trade.
An option strategy will maximize profit when the underlying stock price at expiration is near the middle strike price of the sold calls/puts. The stock price needs to be between the two short strikes for both options to expire worthless, allowing you to keep the entire net credit received when entering this trade.
It's easy to see how this strategy can be implemented using calls or puts. However, it's important to note that the underlying stock needs to be trading slightly above or below one of your short strikes for this trade to profit at expiration.