The iron condor is an option strategy that involves two calls and two puts, each with the same expiration date, but different strike prices.
The iron condor is a useful strategy when an investor wants to profit from a security with low volatility. This article will give investors the basic understanding needed to use this safe and effective option strategy.
The iron condor is very similar to the iron butterfly. Just like the iron butterfly, the iron condor has limited upside and downside risk with limited potential profit. The high and low strike options, also known as the wings, protect against significant increases or decreases in the underlying security’s price.
This strategy is most profitable when each of the options expire worthless, which is only possible if the price of the underlying security closes between the two middle strike prices.
The iron condor is constructed by doing these four things:
- Buy one “out-of-the-money” put option with a strike price below the current market price of the underlying security. This option protects against a significant downside move in the price of the underlying security.
- Sell one “at-the-money” put option with a strike price slightly below the current market price of the underlying security.
- Sell one “at-the-money” call option with a strike price slightly above the current market price of the underlying security.
- Buy one “out-of-the-money” call option with a strike price above the current market price of the underlying security. This option protects against a significant upside move in the price of the underlying security.
The premiums for the “out-of-the-money” options are lower than the premiums for the “at-the-money” options. Therefore, selling the “at-the-money” options pays for the “out-of-the-money” options.
Let’s look at an example of this strategy.
Assume stock XYZ is trading at $100. An investor executes the iron condor by buying one put option with a strike price of $90, selling one put option with a strike price of $95, selling one call option with a strike price of $105, and buying one call option with a strike price of $110. They each expire in one month.
The investor paid $50 each to buy the put and call option. The investor sold the other put and call option for $100 each. From these transactions, the investor enters the trade with a profit of $100 ((2*100) – (2*50) = 100). This is his maximum potential profit.
If stock XYZ expires at $100 in one month, then each option will expire worthless. The investor keeps his maximum profit of $100.
If stock XYZ expires at $90 in one month, all of the options expire worthless, except for the put option sold with a strike price of $95. This option would be exercised, thus obligating the investor buy the shares of stock at $95 rather than $90. Because of this, the investor incurs a loss of $500. However, he did receive a profit of $100 entering the trade. Therefore, his total loss becomes $400 (500 – 100 = 400). This is his maximum possible loss.
If stock XYZ expires at $110 in one month, then a similar scenario would occur. All options would expire worthless, except for the call option sold with a strike price of $105. This option would be exercised, thus obligating the investor to sell the shares of stock at $105 rather than $110. This causes a loss of $500 for the investor. However, the investor did enter the trade with a $100 profit from the premium. Therefore, his total loss becomes $400.
If stock XYZ expires at $85 in one month, then both call options would expire worthless, but both put options would be exercised. The put option sold with a strike price of $95 would cost the investor $1000. The put option bought with a strike price of $90 would generate a profit of $500 for the investor. From these two transactions, the investor would be at a loss of $500. After factoring in the $100 premium received, the total loss becomes $400. This proves that no matter what happens, the maximum loss is still $100.
These scenarios show a few possible results when using the iron butterfly strategy. Ideally, the price of the underlying security expires in-between the two middle strike prices. This generates the maximum profit an investor can receive from this strategy.
The iron condor option strategy is a low-risk way of profiting from insignificant moves in the price of an underlying security. It offers investors a useful tool to generate a profit when a stock’s price is neither moving up nor down.
