Iron Condor Spread

When to Use an Iron Condor Spread

The iron condor spread is a neutral strategy, so it's used when you are expecting little price movement in a security. As we have mentioned above, it can return the maximum profit even if the underlying security moves a little in either direction, so it's a good choice if you think there may be a small amount of volatility. It's a complicated strategy, so it shouldn't really be used by traders without a decent level of experience.

How to Use an Iron Condor Spread

Just like the iron butterfly spread, the iron condor spread has four legs meaning you need to place four orders with your broker. A combination of puts and calls are involved, and you need to both buy and write options. The four trades that are required are as follows.

• Buy out the money calls
• Sell out of the money calls (lower strike than above)
• Buy out of the money puts
• Sell out of the money puts (higher strike than above)

The amount of options bought or sold in each of the legs should be the same, as should the expiration dates used. The two short legs should use strikes that are equidistant from the current trading price of the underlying security, as should the two long legs. It's up to you, though, to decide exactly which strikes you use.

The further away from the current price the strikes of the long legs, the lower the possibility of the spread returning a loss, but the potential loss will be higher. The bigger the difference between the strikes of the short legs, the wider the range for maximum profit will be, but the potential profit will be lower.

Here is an example of the iron condor spread to give you an idea of how it can be used. We should point out that we have used simplified, hypothetical options prices in the example rather than real market data. Also, we have ignored any commissions that would be involved.

• Company X stock is trading at $50, and your expectation is that the price will stay relatively close to that price.
• You buy 1 contract (100 options, $.50 each) of out of the money calls (strike $54) at a cost of $50. This is Leg A.
• You write 1 contract (100 options, $1 each) of out of the money calls (strike $52) for a credit of $100. This is Leg B.
• You buy 1 contract (100 options, $.50 each) of out of the money puts (strike $46) at a cost of $50. This is Leg C.
• You write 1 contract (100 options, $1 each) of out of the money puts (strike $48) for a credit of $100. This is Leg D.
• The total credit received is $200 and the total cost is $100. You have created an iron condor spread for a net credit of $100.

Profit & Loss Potential

The iron condor will generate the maximum possible return when the underlying security trades at a price within the strike of the two short legs (i.e. Legs B & D). In the case of this example, the price of the underlying security must be between $48 and $52. This will result in all four legs expiring out of the money, and you will keep the amount of the net credit as your profit.

The spread will have two break-even points either side of this range, and you will still make a profit (albeit a lower one) if the price of the underlying security is between those two points. If it goes outside this range, you will make a loss.

We have summarized the various formulas that can be applied to the iron condor spread below, as well as providing the results of some hypothetical scenarios.

• If the price of Company X stock stayed exactly at $50 by the time of expiration, the options bought in Legs A and C would remain out of the money and expire worthless. The ones written in Legs B and D would remain at the money and also expire worthless. Your profit would be the net credit. This would also be the case if the underlying security was anywhere between $48 and $52.
• If the price of Company X stock went up to $54 by the time of expiration, the options bought in Leg A would be at the money and worthless. The ones written in Leg B would in the money and worth around $2 each, for a total liability of $200. The ones in Legs C and D would be out of the money and worthless. You would have an overall liability of $200, so your total loss would be $100 after accounting for the initial net credit.
• If the price of Company X stock went down to $46 by the time of expiration, then the options in Legs A and B would be out of the money and worthless. The ones bought in Leg C would be at the money and worthless. The ones written in Leg D would be worth around $2 each, for a total liability of $200. You would have an overall liability of $200, so your total loss would be $100 after account for the initial net credit.
• Maximum profit is made when “Price of Underlying Stock is < Strike Price in Leg B and > Strike Price in Leg D”
• Maximum profit is the net credit received
• There are two break-even points (Upper Break- Even point and Lower Break-Even Point)
• Upper Break-Even Point = “Strike of Leg B + (Net Credit/Number of Options in each leg)”
• Lower Break-Even Point = “Strike of Leg D - (Net Credit/Number of Options in each leg)”
• The iron condor will return a profit if “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
• The iron condor will result in a loss if “Price of Underlying Security > Upper Break-Even Point or < Lower Break-Even Point”
• The maximum loss will be made if “Price of Underlying Security = or > Strike Price of Leg A” or “Price of Underlying Security = or < Strike Price of Leg C”.

Summary

The iron condor spread is a good alternative to the iron butterfly spread if you are trying to profit from a neutral outlook. Although the maximum potential profit is lower, the likelihood of making that profit is higher, because the iron condor generates maximum returns when the underlying security is trading within a price range rather than at an exact price.

The downsides are similar to those of the iron butterfly; it's a complicated strategy and four legs means higher commission charges.