The Iron Condor Strategy: Limited Reward with Limited Risk

Iron Condor Strategy Iron condor spreads are option-trading strategies combining two credit spreads (one bull put spread, one bear call spread) into a four-legged strategy with limited reward and limited risk. Largely because of their finite risk, iron condors are popular among investors seeking investing alternatives for range-bound stocks or indexes. Potential reward and potential risk aren't the only factors that are limited in this strategy; generally the investor is anticipating limited movement in the underlying as well.

Typically speaking, the two calls and two puts in an iron condor are on the same underlying security with the same expiration month. Investors most commonly use iron condors to collect premium by selling a bull put spread and simultaneously selling a bear call spread, netting a credit on both sides of the transaction.

Join us next Tuesday for our next edition of our Two Traders, One Strategy webinar series, which will focus on the iron-condor strategy. Join Bill Sullivan and Steve Claussen as they highlight the pros and cons of the iron condor trade.

Primary Applications:

Investors who think the underlying stock will trade in a range between now and expiration might invest in this strategy. The out-of-the-money (OTM) call option and OTM put option act as hedges in case the stock price moves either sharply higher or sharply lower, respectively.
Investors might use this strategy to sell implied volatility on the underlying, if they expect volatility to come in during the life of the spread.

How to Trade Iron Condors – An Example:

For an example of the iron condor trade, let's revisit a bulls/bears column from last month. While the prices are no longer valid, the mechanics of the trade are still a good demonstration of how this strategy works.

With Amazon trading at $176.77, an investor might have opted to sell a January-dated iron condor by placing the following orders:

Buy the January 150 put
Sell the January 155 put
Sell the January 195 call
Buy the January 200 call

At the time of execution, the trader could have collected a net credit of $1.30 for all four legs. Note that all of the options are out-of-the-money. In this example, the trader would be hoping AMZN would trade in a range between the short strikes (155 and 195) through expiration (or at least until the iron condor was closed).

The investor will reach the maximum potential profit – the $1.30 credit collected – if AMZN is trading between these levels when the options expire. The maximum loss of $3.70 (the difference in call or put strikes less the credit collected) occurs if AMZN is trading below 150 or above 200 at expiration. Assuming the investor does not take delivery of the shares at expiration, losses are limited to this amount no matter how far the stock declines or advances. With this and all other option strategies, it's important to manage your trades around expiration and avoid the risks inherent with automatic exercise.

The two breakeven prices in this example are $153.70 to the downside (the short put strike less the credit collected) and $196.30 to the upside (the short call plus the credit). As long as the stock trades between these prices through expiration, the investor will make money on this spread trade.

Profit and loss of Amazon.com (AMZN) iron condor

One downside to the iron condor is the commissions required to enter and exit the trades. Check with your brokerage firm to see if they have special rates for trading spreads. Many will not charge any more for an iron condor beyond the initial ticket charge for a two-legged spread. (For information on OptionsHouse spread-trading commissions, visit our rates page).

Photo Credit: ghewgill

The above information is provided by OptionsHouse, LLC (“OptionsHouse”) for informational and educational purposes only and is not intended as trading or investment advice or a recommendation that any particular security, transaction, or investment strategy is suitable for any specific person. You are solely responsible for your investment decisions. Commentary and opinions expressed are those of the author/speaker and not necessarily of OptionsHouse. Neither OptionsHouse nor any of its employees, officers, shareholders or affiliated companies guarantee the accuracy of or endorse the views or opinions of guest speakers or commentators. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature and are not guarantees of future results. Any examples used that discuss trading profits or losses may not take into account trading commissions or fees.

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