The Iron Condor

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The Iron Condor

Iron condors are a popular option strategy utilized by professional money managers and ordinary investors. Let’s start with an explanation of what an iron condor is and how you may profit from knowing how to trade them.

What Is an Iron Condor?

An iron condor is an options strategy that employs four distinct contracts. The following are some of the strategy’s important features:

  • An iron condor spread is created by selling one call spread and one put spread on the same underlying instrument (both with the same expiry day).
  • All four alternatives are frequently out of the money (although it is not a strict requirement).
  • The call and put spreads are the same breadth. Thus, if the strike prices of the two call options are 10 points away, the strike prices of the two puts should be 10 points apart as well. It is important to note that it makes no difference how far apart the calls and puts are.
  • The underlying asset is often one of the broad-based market indexes, such as SPX, NDX, or RUT. Many investors, however, prefer to have iron condor bets in individual equities or smaller indices.
  • You acquire the iron condor when you sell the call and put spreads. The cash gathered indicates the position’s maximum profit.
  • It is a’market neutral’ trade, which means it has no intrinsic bullish or negative bias.

Iron Condor Positions, Step by Step

Consider the following two hypothetical situations to demonstrate the essential components or stages in purchasing an iron condor:

To buy 10 XYZ Oct 85/95/110/120 iron condors:

  • Sell 10 XYZ Oct 110 calls
  • Buy 10 XYZ Oct 120 calls
  • Sell 10 XYZ Oct 95 puts
  • Buy 10 XYZ Oct 85 puts

To buy three ABCD Feb 700/720/820/840 iron condors:

  • Sell three ABCD Feb 820 calls
  • Buy three ABCD Feb 840 calls
  • Sell three ABCD Feb 720 puts
  • Buy three ABCD Feb 700 puts
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How Do Iron Condors Make/Lose Money?

When you hold an iron condor, you’re hoping that the underlying index or securities will trade in a reasonably limited trading range from the moment you begin the position until the options expire. When expiry comes, if all options are out-of-the-money, they expire worthless, and you retain every cent (less fees) you paid when you purchased the iron condor. Expect that perfect opportunity to arise sometimes, but it will.

It is often advisable to give up the remaining few nickels or dimes of prospective profit and close the trade before expiry. This enables you to lock in a high profit while eliminating the possibility of losses. The capacity to control risk is a necessary skill for all traders, particularly those who use this technique.

Markets are not always so flexible, and underlying indices or securities prices may be erratic. When this occurs, the underlying asset (in the previous cases, XYZ or ABCD) may see a large price movement. Because that’s not good for your position (or your bank account), you should be aware of two key points:

  • How much you can lose; and
  • What you can do if the market acts badly.

Maximum Loss Potential

When you sell 10-point spreads (as with XYZ), the worst-case scenario is that XYZ moves so far that both calls and puts are in the money when expiry comes (XYZ is above 120 or below 85). The spread is worth the maximum amount in such case, or 100 times the difference between the strike prices. In this case, 100 x $10 is $1,000.

The worst that may happen since you bought ten iron condors is that you are compelled to pay $10,000 to cover (close) the position. If the stock continues to rise, you will be unaffected. Because the spread can never be worth more than the difference between the strikes, the fact that you possess the 120 call (or 85 put) protects you against additional losses.

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Loss Buffer in Premiums

There is some good news: remember that when you acquire the position, you get a cash premium, which helps to buffer losses. Assume you earn $250 every iron condor. Subtract $250 from the $1,000 limit to get the maximum amount you may lose each iron condor. In this case, it’s $750.

Keep in mind that if you keep the position until the options expire, you can only lose money on one of the spreads; they cannot both be in-the-money at the same time.

Depending on whatever options (and underlying assets) you select to purchase and sell, a variety of outcomes may occur:

  • Loss likelihood may be lowered, but reward potential is also diminished (choose further out-of-the-money options).
  • The reward potential may be enhanced, but the likelihood of achieving that reward decreases (choose options that are less far out-of-the-money).
  • Finding solutions that are inside your comfort zone may need some trial and error. Stick to indices or sectors that you are highly familiar with.

Introduction to Risk Management

Although the iron condor is a low-risk strategy, it doesn’t imply you should sit back and watch your money go when things don’t go your way. Although understanding how to control risk when trading iron condors is critical to your long-term performance, a comprehensive explanation of risk management is beyond the scope of this article.

Just as you do not always get the full profit when the trade is advantageous (due to the fact that you close before expiry), you often lose less than the maximum when the situation swings against you. This might happen for a variety of reasons, including:

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  • You may opt to close early in order to avoid higher losses.
  • XYZ may change direction, enabling you to maximize your profit.
  • XYZ may not make it all the way to 120. If XYZ’s expiry price (settlement price) is 112, the 110 call is in-the-money by two points and is only worth $200. When you purchase back that option (the other three options expire worthless), you may have made a little profit – in this case, $50.

Practice Trading ina Paper-Trading Account

Even if you are an experienced trader, consider creating a paper-trading account with your broker if this method appeals to you. The goal is to develop experience without risking any money. Select two or three distinct underlying assets, or a single one with varying expiry months and strike prices. As time passes and markets shift, you’ll observe how various iron condor positions perform.

The primary goal of paper trading is to determine if iron condors are a good fit for you and your trading style. It is critical to hold jobs inside your comfort zone. It’s great when the risk and return of a job enable you to be worry-free. When your comfort zone is breached, it’s important to adjust your portfolio to remove the holdings that cause you discomfort.

Summary

Iron condors enable you to invest in the stock market with a neutral bias, which many traders like. This option method also enables you to hold positions with little risk and a high likelihood of success.

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