Understanding Iron Condors

Trading options can be a complicated process. Information overload among the uninitiated is prevalent, as a lot of options strategies are available and traders need to evaluate all of the possible routes ahead of executing a trade. As such, Schaeffer's is  starting a new educational series titled Optimizing Your Options Strategies. The beauty of options trading is that there are options strategies for every market environment. In this series, we will cover all available options strategies for an educated trader to consider when identifying trading opportunities.

One of the most popular options strategies with arguably the best name in the investing world is the iron condor. An iron condor is a multi-legged strategy created with four options on a single underlying stock consisting of two puts (one long and one short) and two calls (one long and one short) and all options have different strike prices, but have the same expiration date.

Iron condors are used by options traders to profit from low-volatility environments with little to no movement in the underlying stock. In other words, the iron condor options strategy is designed to earn the maximum amount of money available when the underlying stock price closes between the middle strike prices at expiration.

How do Iron Condors Work?

The iron condor options strategy has limited upside and downside risk due to the high and low strike priced options included in the trade, which combine to protect against any significant moves in either direction. In exchange for the limited risk the iron condor options strategy provides, the profit potential is capped. To reach optimal profits using iron condors, the trader ideally would like all the four options to expire worthless. This is only possible if the underlying stock closes between the middle of the two strike prices at expiration.

An important thing to note though is that the commission charged can become pretty significant in this strategy, due to the four options contract involved here. So, please make sure to pay attention to commission rates at your brokerage before beginning to implement multi-legged strategies like iron condors.

There are two types of iron condor options strategies used dependent on the expected direction of the underlying stock.

The long iron condor option strategy consists of a bear put spread and a bull call spread in which the strike price of the long put is lower than the strike price of the long call. A long iron condor options strategy is a net debit strategy. Both the potential profit and potential risk are limited. The maximum profit potential is realized if the stock price is above the highest strike or below the lowest strike price at expiration. The long iron condor options strategy is advanced because the profit potential is seriously hindered by the fees and commission charged for trading four options contracts with four different strike prices.

The maximum profit potential using the long iron condor strategy is the maximum value of the bear put spread or the bull call spread minus the net debit paid for the position. There are two possible outcomes in which the maximum profit is realized. If the stock price is below the lowest strike price at expiration or the stock price is above the highest strike price at expiration.

The maximum risk taken on in a long iron condor options trade is realized if the underlying stock price is equal to or between the long options' strike price on the expiration date, in which case, all the options expire worthless.

There are two breakeven points when utilizing the long iron condor options strategy. The lower breakeven point is when the stock price is equal to the strike price of the long put minus the net debit, and the upper breakeven point is the stock price is equal to the strike price of the long call plus net debt paid.

The short iron condor options strategy consists of a bull put spread and a bear call spread in which the strike price of the short put is lower than the strike price of the short call. A short iron condor is a net credit strategy, and both the potential profit and potential loss is limited. The maximum profit is realized if the stock price is equal to or between the short options' strike prices on the expiration date. The short iron condor options strategy is considered an advanced options strategy because the profit potential is seriously hindered by the fees and commission charged for trading four options with four different strike prices.

The short iron condor strategy's maximum profit potential is equal to the net credit received minus the fees and the commissions. The maximum profit is realized when the stock price is equal to or in between the short options' strike prices at expiry.

The maximum risk taken on in a short iron condor options trade is realized if the difference between the bear spread's price put spread minus the net credit received. There are two possible outcomes where maximum risk is realized. If the stock price is below the lowest strike price option at expiration or the stock price is above the highest strike price option at expiration.

There are two breakeven points when utilizing the short iron condor options strategy. The lower breakeven point is when the stock price is equal to the strike price of the short put minus the net credit, and the upper breakeven point is the stock price is equal to the strike price of the short call plus net credit received.