Iron Condor
Outlook: Expecting minimal price movement; bearish on volatility

The iron condor is a four-legged options strategy intended to capitalize on a period of muted, low-volatility price action in the underlying security. This play is essentially the combination of a short call spread with a short put spread, and -- like both of those strategies -- the maximum potential profit is limited to an initial net credit.

Alternately, the iron condor can be thought of as a hedged version of the short strangle. The two sold options at the inner strikes form the "body" of the condor, while two purchased options at the outer strikes represent the "wings." Due to those purchased options at the outer strikes, the iron condor has a considerably more conservative risk profile than the short strangle.

To understand how this many-legged spread works, let's break down an example.

Entering the Trade

Stock XYZ is relatively sedate, and the shares have spent the past couple of weeks consolidating in a narrow range between the $25 and $27 levels. You expect this sideways channel to hold firm during the near term, so you decide to implement an iron condor using these two price points as your focus strikes.

Simultaneously, you sell to open the 25-strike put, bid at 0.15, and buy to open a 24-strike put, asked at 0.06. For the other half of the condor, you simultaneously sell to open a 27-strike call, bid at 0.13, and buy to open the 28-strike call, asked at 0.03. You collected a total of 0.28 (0.15 + 0.13) on the sold options, and spent 0.09 (0.06 + 0.03) on the purchased options, for a net credit of 0.19 (0.28 - 0.09). Multiplying your upfront credit by 100 shares per contract, you've netted $19 upon entering the spread.

Potential Gains

As with the short call spread, short put spread, and short strangle, your maximum possible gain on an iron condor is limited to the initial net credit. You'll retain this entire amount if XYZ remains between the two sold strikes through expiration, in which case all four options can be left to expire worthless.

There are two breakeven rails on this trade: the sold call strike plus the net credit (27.19), and the sold put strike minus the net credit (24.81). However, if one of your sold options moves into the money prior to expiration, you may want to buy to close the contract to avoid assignment -- thereby incurring an additional transaction fee.

Potential Losses

Because each of your sold options is hedged by a purchased option at a nearby strike, your risk profile on an iron condor is clearly defined.

If XYZ should rally above the strike price of the purchased call, the most you can lose is limited to the difference between the bought and sold call strikes, less the net credit -- or [(28 - 27) - 0.19] = 0.81.

Similarly, if XYZ falls below the purchased put strike, the most you can lose is limited to the difference between the bought and sold put strikes, less the net credit -- again, [(25 - 24) - 0.19) = 0.81.

In both scenarios, this amount would be multiplied by 100 shares per contract, resulting in a maximum possible loss of $81.

Volatility Impact

The iron condor has two sold options at its core, and option sellers typically benefit from declining implied volatility. All other things being equal, lower implied volatility makes it cheaper to buy back the options, if needed. However, since an iron condor involves two bought and two sold options, the overall impact of implied volatility is somewhat muted.

Other Considerations

The success of an iron condor depends upon the stock staying in a relatively tight range throughout the lifespan of the trade. Make sure you're confident in the technical outlook for the security as you select your focus strikes. Additionally, it makes sense to focus on shorter-term options, which afford the shares less time to move against you.

In the same vein, be aware of any upcoming events -- such as a quarterly earnings report, for example -- that could trigger a big move in the stock. You may also want to avoid equities with high short interest-to-float ratios, since a short-squeeze rally can play havoc with an iron condor.