Understanding Iron Condors, Part I
Iron condors are one of my recommended strategies for option traders. But please be certain you have a firm understanding of how options work before adopting this strategy I suggest learning how to write covered calls as your entry into the options world.
An iron condor is a spread that contains four different option series. It’s a market neutral strategy and does best when the underlying asset trades within a narrow range. This strategy is not for investors who believe the underlying stock or index is going to make a substantial move (in either direction) before the options expire.
- All options use the same underlying asset
- All options have the same expiration date
- Two options are calls
- Two options are puts
- Typically, all options are out of the money
When you buy an iron condor, you sell two credit spreads: one call spread and one put spread. The term credit spread means that you collect cash for the spread. (If you pay cash, you buy a debit spread.)
- Sell one call and buy another with a higher strike price
- Sell one put and buy another with a lower strike price
- The options sold have a higher premium (price) than the options bought. Thus, you collect cash for each spread.
Characteristics of traditional iron condors:
- The strike prices of the call spread are as far apart as the strike prices of the put spread (5 points in the example). It does not matter how far apart the calls and puts are from each other.
- An equal number of call spreads and put spreads are sold
EXAMPLE:
Buy 10 ZZX Dec 80 calls
Sell 10 ZZX Dec 75 calls
Buy 10 ZZX Dec 60 puts
Sell 10 ZZX Dec 65 puts
Nomenclature: The example position is ‘long 10-lots of the ZZX December 60/65; 75/80 iron condor’
How does the iron condor position make money? You collected cash for selling two credit spreads. The maximum profit occurs when expiration arrives and all four options are out of the money. For that to happen with our example, at December expiration, if ZZX closes at a price above 65 and below 75, then all options are worthless and your profit is the premium you collected when buying the iron condor position.
You don’t have to wait for expiration. Instead you can sell the iron condor any time you want to do so by buying back the specific spreads sold earlier.
How does the iron condor lose money? When ZZX moves too far and breaks through the strike price of one of the options sold, the position can lose money. If both calls or both puts are in the money when expiration arrives (ZZX below 60 or above 80), then one of the spreads is worth its maximum value. In this example, that’s $500. That maximum value is 100 x the difference between the strike prices of the two calls or the two puts. Your loss is $500 less the original premium collected.
One word of caution: The iron condor is not a ‘set it and forget it’ type of trade. It’s important to manage risk as time passes. Risk management is the subject of a future post.
See Also: Iron Condors Part II, Iron Condors Part III, Iron Condors Part IV, and Iron Condors Part V
Mark Wolfinger is a 20 year CBOE options veteran and is the writer for the blog Options for Rookies. He also is the author of the book, The Rookie’s Guide to Options.
More Articles on Options:
- For Options Beginners, What is an Option?
- 6 Great Options Strategies for Beginners
- 7 Reasons Investors Should Trade Options
- Options Basics Quiz
- 9 Option Terms Every Investor Should Know
- How to Make the Best Options Trades, 6 Keys to Success
- The Key Differences Between Options and Stocks
- Entering an Order to Buy or Sell Options Investor Series, Part I
