Reverse Iron Condor Spread
The reverse iron condor spread is an options trading strategy designed to be used when you are expecting an underlying security to make a sharp move in price, but you aren't sure in which direction that move will be. It's an advanced strategy that involves calls and puts, and it requires a total of four transactions.
At the time of applying this strategy, you'll know exactly how much you stand to make or lose, because the potential profits and the potential losses are both limited. For more information on this strategy please see below.
- Volatile Strategy
- Not Suitable for Beginners
- Four Transactions (buy puts/ write puts/buy calls /write calls)
- Debit Spread (upfront cost)
- Medium Trading Level Required
When to Use the Reverse Iron Condor Spread
As a volatile trading strategy, the reverse iron condor spread is used when you are expecting some volatility in the price of the underlying security. It profits when there's a significant price movement, but it doesn't matter in which direction that price movement is.
This is one of the more complicated strategies and, it isn't particularly recommended for traders that are inexperienced.
How to Use the Reverse Iron Condor Spread
There are four legs involved in this strategy. To keep things simple you can transact all four of the required legs at the same time, but you can choose to use legging techniques if you are comfortable doing so. This can help to maximize the potential profitability.
The four orders required at the outset are as follows.
- Buy out the money puts
- Sell out of the money puts (lower strike than above)
- Buy out of the money calls
- Sell out of the money calls (higher strike than above)
The number of contracts bought or written in each of the four legs should be the same. The expiration date of all contracts should also be the same. The two long legs (where you buy contracts) should both use strikes that are the same distance out of the money. The wider the difference between the strikes of these two legs, the lower the maximum potential loss is.
The two short legs (where you sell contracts) should both be further out of the money than the long legs, by the same distance. The wider the difference between the strikes of these two legs, the less likely the strategy is to return a profit. However, a wider difference also means greater potential profit.
To give you some idea of how the reverse iron condor spread can be used we have provided an example below. For the sake of simplicity we have used hypothetical options prices and ignored commission costs.
- Company X stock is trading at $50, and your expectation is that the price will move significantly in either direction.
- You buy 1 contract (100 options, $1 each) of out of the money puts (strike price $48) at a cost of $100. This is Leg A.
- You write 1 contract (100 options, $.50 each) of out of the money puts (strike price $46) for a credit of $50. This is Leg B.
- You buy 1 contract (100 options, $1 each) of out of the money calls (strike price $52) at a cost of $100. This is Leg C.
- You write 1 contract (100 options, $1 each) of out of the money calls (strike price $54) for a credit of $50. This is Leg D.
- The total spent is $200 and the total credit received is $100. You have created a reverse iron condor spread for a net debit of $100.
Profit & Loss Potential
For this strategy to return a profit the price of the underlying security must move below the strike of the options in Leg A or above the strike of the options in Leg C. It will result in a loss if the price doesn't move far enough in either direction, or if it stays the same.
You can calculate the exact break even points of this strategy at the time of applying it. You can also calculate the maximum potential profit and the maximum potential loss. We have listed the calculations you need to make below, together with the results of some hypothetical scenarios.
- If the price of Company X stock stayed exactly at $50 by the time of expiration, the options in all legs would expire worthless. There are no returns to come and no further liabilities, so the loss is the initial net debit of $100.
- If the price of Company X stock went up to $56 by the time of expiration, the puts bought in Leg A would be out of the money and worthless. The puts sold in Leg B will also be worthless. The calls bought in Leg C would be in the money and worth around $4 each, for a total asset of $400. The calls written in Leg D would be in the money and worth around $2 each, for a total liability of $200. This gives you a profit of $200, less the initial debit of $100 for a total profit of $100.
- If the price of Company X stock went down to $44 by the time of expiration, the puts bought in Leg A would be worth around $4 each and $400 in total. The puts written in Leg B would be worth around $2 each and $200 in total. The calls in Legs C and D would all be worthless. You have a liability of $200 and assets of $400. Less your $100 initial debit you have made $100.
- Maximum profit is made when “Price of Underlying Stock = or < Strike of Leg B” or “Price of Underlying Stock = or > Strike of Leg D”
- Maximum profit is “((Strike in Leg A – Strike Leg B) x Number of Options in Leg A)) – Net Debit”
- There are two break-even points (Upper Break- Even point and Lower Break-Even Point)
- Upper Break-Even Point = “Strike Price of Leg C + (Net Debit/Number of Options in each leg)”
- Lower Break-Even Point = “Strike Price of Leg B - (Net Debit/Number of Options in each leg)”
- The reverse iron condor spread will return a profit if “Price of Underlying Security > Upper Break-Even Point or < Lower Break-Even Point”
- The reverse iron condor spread will result in a loss if “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
If you are expecting a security to move significantly but are not sure in which direction it will move, this is a good strategy for a couple of reasons. The maximum profit and the maximum loss are both predictable, and you are able to adjust the strikes to determine how much you wish to make and how much you need the price of the security to move by.
The main downside is that it's a complicated strategy to use. The fact that there are four legs involved also means that you will pay a fair amount in commission charges.