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IRON CONDOR

By ProbabilityofProfit.com

An iron condor strategy is a versatile options trading approach that aims to capitalize on a period of low volatility in the underlying asset. This strategy involves simultaneously implementing both a put credit spread and a call credit spread with the same expiration date but different strike prices.
Traders utilize iron condors when they expect the underlying asset to trade within a specific range, predicting minimal price movement. The goal is to profit from the time decay of both the put and call options, taking advantage of the variance in premiums while limiting the potential maximum loss. This strategy thrives in stable market conditions, where the price of the underlying asset remains relatively stagnant.

HOW IT WORKS

BASIC STRUCTURE

  1. Short Call
    • Sell a call option.
  2. Long Call
    • Buy a call option.
  3. Short Put
    • Sell a put option.
  4. Long Put
    • Buy a put Option.

FUNDAMENTALS

  1. Long call price cannot be greater than or equal to Short call price
    • Short call Price > Long call Price 
  2. Short call strike cannot be greater than or equal to Long call strike 
    • Long call Strike > Short call Strike 
  3. Long put price cannot be greater than or equal to Short put price 
    • Short put Price > Long put Price 
  4. Short put strike cannot be less than or equal to Long put strike 
    • Short put Strike > Long put Strike 
  5. Short call strike cannot be less than Short put strike 
    • Short call Strike > Short put Strike
       

KEY TAKEAWAYS

NEUTRAL STRATEGY

The iron condor strategy is considered a neutral strategy rather than strictly bullish or bearish.
  • It profits when the underlying asset remains within a certain price range, and it will incur losses if the price of the underlying asset moves too far in either direction.

LIMITED PROFIT & RISK

The strategy is designed to generate a limited profit with limited risk.
  • The maximum loss and maximum gain are both known before entering the trade.
  • The goal is to collect a premium by selling options while managing risk through the purchase of options with wider strike prices.

TIME DECAY ADVANTAGE

Time decay, also known as theta decay, works in favor of iron condor traders.
  • As time passes, the options lose value, and if the underlying asset remains within the expected range, the trader can profit from the diminishing value of the options they sell.

PROS & CONS

PROS

CONS

Limited Risk: The risk is limited to the difference between the strike prices of the long and short options in both the call and put spreads. This makes it a defined-risk strategy.

Limited Profit Potential: While the risk is limited, so is the profit potential. The maximum profit is capped at the premium received from selling the call and put options. If the market makes a significant move, potential profits may be limited.

Income Generation: Iron condors are popular for income generation. Traders receive a premium from selling both the call and put options, and if the price stays within the expected range, the options expire worthless, allowing the trader to keep the premium.

Risk of Assignment: There's a risk of early assignment, particularly if one leg of the condor is in the money. This can lead to additional transaction costs and potentially unexpected market exposure.

Time Decay (Theta): Time decay works in favor of iron condor traders. As time passes, the value of the options decreases, contributing to potential profits if the price remains within the expected range.

Market Risk: If the underlying asset experiences a sudden and significant price movement beyond the expected range, it can result in losses. Extreme market events may lead to losses that exceed the premium received.

Range-Bound Profits: The strategy is profitable when the underlying asset's price stays within a specific range, providing a favorable environment for market conditions that lack significant directional movement.

Requires Active Management: Successful implementation of iron condors often requires active management. Traders may need to adjust or close out positions before expiration to avoid potential losses or to capitalize on changing market conditions.

 

Margin Requirements: Some brokers may require margin to execute iron condor trades, which ties up capital. Additionally, if adjustments are needed, it might require additional margin.
 

UNDERSTANDING ASSIGNMENT RISK

SHORT STRANGLE AND OPTION ASSIGNMENT

The assignment risk in an iron condor arises from the short options (both the short put and the short call) that you have sold. If the price of the underlying asset moves beyond the strike price of either the short put or the short call, there is a chance that the option could be exercised by the option holder. 
  • If the short put is assigned, you would be obligated to buy the underlying asset at the strike price.
  • If the short call is assigned, you would be obligated to sell the underlying asset at the strike price. Assignment can happen at any time before the expiration date, although it is more likely to occur if the option is in-the-money. 
To manage assignment risk with an iron condor, traders can take several actions:
  1. Close the Position: If the price of the underlying asset approaches one of the short strikes, you may choose to close out the entire iron condor position before the options are exercised. This helps avoid assignment risk but may result in a loss if the position is closed at a less favorable price.
  2. Roll the Position: Traders may choose to roll the iron condor by buying back the short options that are in danger of being assigned and simultaneously selling new options with a later expiration date and/or different strike prices. This allows the trader to maintain the position and potentially collect more premium.
  3. Adjust Strikes: Adjusting the strike prices of the short options in response to changing market conditions can help manage assignment risk. This may involve widening or narrowing the spread between the short put and short call.

EXAMPLE

SHORT STRANGLE EXAMPLE

Suppose an investor holds a neutral view of the SPDR Dow Jones Industrial Average ETF Trust (DIA) for the upcoming nine days. Envisioning the stock's current trade at $347.47 per share, the strategy chosen to express this neutral outlook involves the execution of a credit spread. In this scenario:
  1. Pair one:
    1. Buys for $3.00 one put option with a strike of $340 expiring in nine days
    2. Sells for $4.00 one put option with a strike of $345 expiring in nine days
  2. Pair two:
    1. Sells for $3.50 one call option with a strike of $350 expiring in nine days
    2. Buys for $2.50 one call option with a strike of $355 expiring in nine days
 
This strategic move results in a net credit of $2.00 for the pair of two option spreads, this is derived from: 
  • Net credit from puts: $4.00 (sold) - $3.00 (bought) = $1.00 
  • Net credit from calls: $3.50 (sold) - $2.50 (bought) = $1.00 
  • Total net credit: $1.00 + $1.00 = $2.00 or $200 per contract (since each options contract represents 100 shares).
     

MAXIMUM PROFIT SCENARIO

Suppose DIA experiences a neutral movement, reaching $343 at the time of expiry. This results in the attainment of maximum profit, amounting to the amount of the credit ($200). 
It's important to note that once the stock surpasses the $343 breakeven price at expiry, the strategy plateaus until reaching the higher strike price, and no additional profit accrues beyond this point. The price must fall between either of the long and short strike prices by expiration for this strategy to properly function.
 

MAXIMUM LOSS SCENARIO

Should the DIA shares hover between $345 and $350, the maximum loss comes into play. Yet, this loss is confined to a maximum of $300, calculated as the difference between the short put strike (345) and the long put strike (340) times (100) shares subtracted by the entry credit (200).
 
  1. (((Put Short Strike - Put Long Strike) * 100) - Entry Credit) = Maximum Loss 
  2. ((($345 - $340) * 100) - $200) = $300

 

The investor's undesirable scenario envisions the stock concluding between the $345 and the $350 strike spread upon expiration, thus marking the potential loss for this investor of $300.

BREAKEVEN POINT

The breakeven points are calculated using two different formulas. The breakeven point for the short put is calculated as the strike price of the short put minus the net credit received. The breakeven point for the short call is calculated as the strike price of the short call plus the net credit received. 
  1. Breakeven Point for Put Options: 
    • Short put strike price: $345
    • Net credit received: $2.00 per share ($200 for the contract, as each option contract represents 100 shares)
    • Breakeven for short put = $345 - $2.00 = $343 per share
  2. Breakeven Point for Call Options: 
    • Short call strike price: $350
    • Net credit received: $2.00 per share ($200 for the contract)
    • Breakeven for short call = $350 + $2.00 = $352 per share 
The strategy will breakeven on the downside if the stock price of DIA at expiration is at or below $343 per share and will breakeven on the upside if the stock price of DIA at expiration is at or above $352 per share. The investor profits if the stock price of DIA remains between $343 and $352 at expiration, capturing the entire initial credit of $200 while losses occur if DIA's stock price moves significantly outside this range at expiration.
 

CONCLUSION

In summary, the iron condor strategy presents a versatile approach for traders expecting minimal volatility in an underlying asset. By simultaneously implementing put and call credit spreads, traders seek to capitalize on time decay while managing risk through defined maximum loss and profit potential. This strategy thrives in stable market conditions, offering income generation from premiums if the asset remains within the expected range. To effectively navigate potential assignment risks and maximize profitability, active management and strategic adjustments are crucial. Mastering the iron condor strategy empowers traders to navigate neutral market environments with confidence and precision. Happy trading!

REFERENCES

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