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Iron Condor is a non-directional option strategy, whereby an option trader combines a Bull Put spread and Bear Call spread to generate profit. In this strategy, there is a high probability of limited gain. An option trader resorts to this strategy if he believes that the market is going to be range bound. The maximum profit in an Iron Condor strategy is equal to the net premium received adjusted for commissions. The maximum loss occurs when the price of the underlying security is higher than the strike price of the Long Call or when the price of the underlying security is less than the strike price of the Long Put.
Understanding
Iron Condor options involve the use of both Call and Put options to generate profit for the option trader. In a Call option trade, the two counter-parties involved are Call Option writer and Call Option buyer. The two parties have counter-views on the direction of the security price. The Call Option buyer believes that the price of the underlying security is going to rise while the Call Option writer believes that the price of the underlying security is going to fall.
Buying an option gives the buyer the right, but not the obligation, to acquire the security at a fixed price, called the Strike Price, within a certain date called the expiry date. If the Strike Price is less than the current market price of the underlying security, then the option is said to have an intrinsic value. This means that the option buyer will find it worthy to exercise his right. This scenario is also called in the money.
To construct an iron condor, here’s what you need to do.
Sell an out-of-the-money put
Sell an out-of-the-money call
Buy a further out-of-the-money put
Buy a further out-of-the-money call
Say a company is trading at Rs. 50 in February. Here’s what you sell or buy to execute the iron condor strategy. All the options have a lot size of 100 shares.
You buy one March put option with a strike price of Rs. 40 (at a cost of Rs. 50)
You buy one March call option with a strike price of Rs. 60 (at a cost of Rs. 50)
You sell one March put option with a strike price of Rs. 45 (for a price of Rs. 100)
You sell one March call option with a strike price of Rs. 55 (for a price of Rs. 100)
So, at the outset, your overall gain is Rs. 100 (since you received Rs. 200 for the options sold and paid Rs. 100 for the options bought).
Now, at expiry, if the price of the underlying stock closed anywhere between Rs. 45 and Rs. 55, here’s what will happen. Say the stock price on expiry is Rs. 52.
Option 1 would expire worthless, since it gives you the right to sell at Rs. 40 (instead of Rs. 52)
Option 2 would expire worthless, since it gives you the right to buy at Rs. 60 (instead of Rs. 52)
Option 3 would expire worthless, since it gives the buyer the right to sell at Rs. 45 (instead of Rs. 52)
Option 4 would expire worthless, since it gives the buyer the right to buy at Rs. 55 (instead of Rs. 52)
So, all in all, you will be left with the initial gain of Rs. 100 if you follow the iron condor strategy in this scenario.
On the other hand, if the stock closes below Rs. 45 or above Rs. 55, you will incur a loss. For instance, say the stock closes at Rs. 40 on expiry. In that case, here are the outcomes.
Option 1 would expire worthless, since it gives you the right to sell at Rs. 40 (which is the same as the market price)
Option 2 would expire worthless, since it gives you the right to buy at Rs. 60 (instead of Rs. 40)
Option 3 would not expire worthless, since it gives the buyer the right to sell at Rs. 45 (instead of Rs. 40)
Option 4 would expire worthless, since it gives the buyer the right to buy at Rs. 55 (instead of Rs. 40)
So, with regard to option 3, you will incur a loss of Rs. 5 per share (i.e. Rs. 45 minus Rs. 40). This becomes a total loss of Rs. 500. Netting it off with the initial gain of Rs. 100, you end up with a net loss of Rs. 400.
Description-
Directional Assumption: Neutral
Setup-
- Sell OTM Call Vertical Spread
- Sell OTM Put Vertical Spread
Ideal Implied Volatility Environment: High
Max Profit– The maximum profit potential for an Iron Condor is the net credit received. Maximum profit is realized when the underlying settles between the short strikes of the trade at expiration.
How to Calculate Breakeven(s)
Upside: Short Call Strike + Credit Received
Downside: Short Put Strike – Credit Received
