Professional individual investors or money managers make use of popular trading strategy called iron condors. Many novice traders are unaware about what it is and how they can gain from learning this technique.
Iron condors is an option strategy, which incorporates four kinds of different contracts. The main features of this strategy includes –
- This framework is created by selling one call as well as one put spread on same underlying asset having same date expiration.
- All the 4 options are generally out-of-the-money.
- The call and put spread have equal width. For example, if strike rates of 2 call options are suppose 9 points apart then 2 put options must also be 9 parts at a distance. [How much distance the call and put options are at does not matter but both must be equally apart].
- Often, the underlying instrument is extensive market indexes like RUT, NDX, or SPX but several investors opt for iron condors on smaller indexes or personal stocks.
- When call and put options get sold you buy iron condors. Cash collected will represent the total position profit.
Hypothetical example to understand the iron condor’s concept easily
To buy 10 Relic Nov 75/85/100/110
- Sell 10 Relic Nov 100 calls
- Buy 10 Relic Nov 110 calls
- Sell 10 Relic Nov 85 puts
- Buy 10 Relic Nov 75 puts
To buy four Ozone Jan 600/620/720/740
- Sell four Ozone Jan 720 calls
- Buy four Ozone Jan 740 calls
- Sell four Ozone Jan 620 calls
- Buy four Ozone Jan 600 calls
How does iron condors make or lose money?
When you have an iron condor then you hope to have that underlying security within a narrow trading range from time of opening till its expiration. If all the options are OTM, when expiry time nears then they will expire worthless. You get to keep every penny collected, while purchasing iron condors. Such ideal situation does not occur all the time.
At times, it is wise to sacrifice a little of the probable profit and close position prior expiry arrives. It can help to lock good profit, thus averting the risk of losing. Risk management is essential for every trader, especially while applying this technique.
Markets are volatile and not accommodating majority of times. When such happens the underlying options will possibly undergo substantial price fluctuation. This is not good for your technique and you need to comprehend –
- What is maximum loss potential?
- What can be done when market misbehaves?
How much can one lose?
According to above example when 10 point spread is sold, worst scenario occurs when Relic moves very far that both calls and puts are ITM [in-the-money]. When expiry date is near, Relic is above 110 and below 75. In this case, Spread worth is maximum amount or 100 times difference between strike prices – $10 x 100 = $1,000.
As you bought 10 iron condors, to close or cover the position you will need to pay $10,000. Even if stock moves you will not be affected. Actually, you own 110 calls or 75 puts, which offers protection from more losses. The spread cannot cost more than difference between strikes.
Iron condors are included in limited risk strategy but it does not mean you relax and do nothing in case things don’t go as expected. You will need to understand risk management using this technique for long term success.