Editor's note: In this week’s Swim LessonsSM column, Kevin Hincks explains the basics of an Iron Condor. TD Ameritrade clients can join a free, live educational session on Iron Condors by joining Swim LessonsSM in the thinkorswim platform® on Friday May 19th at 10:30 AM CT.
In our daily educational program, Swim LessonsSM, we seek to teach options traders about risk-defined, high probability options trades. In past columns, we’ve covered buying vertical spreads and selling vertical spreads.
Vertical spreads are fairly versatile when making a directional stance. Selling a put vertical spread would be a bullish trade. Selling a call vertical spread would be a bearish trade. But what if you are neutral, or if we’re stuck in a range-bound market? Enter… The Iron Condor.
The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation.
Iron Condor: What’s In A Name?
Don’t be intimidated by this options strategy. We get it – it sounds like the band name you wish you would’ve thought of for your high school garage band, or the name of a video game “super boss” you encounter at the end of the game. However, when you open up the hood of this strategy, it’s really a combination of two fairly basic options strategies, coupled with one awesome sounding name.
An Iron Condor is what you get when you combine an out-of-the-money (OTM) short put spread (bullish strategy) and an OTM short call spread (bearish strategy) using options that all expire on the same date. By selling two different OTM vertical spreads you’re collecting two premiums, but at expiration, the market can’t be in two places. At expiration, only one spread can go against you.
So it sounds like you’re able to bring in the premium for two spreads without increasing your risk, right? Well, yes and no. Here’s an example to explain.
Let’s say you sell the 150-145 put spread and the 160-165 call spread, as an iron condor for a credit of $0.75. The maximum risk on either spread is $5.00 - $0.75, or $4.25 per spread (which is really $425 for a one contract spread) plus transaction costs. At expiration, if the stock is above $150 and below $160, then both spreads expire worthless and you keep the $0.75 ($75 per spread) as the profit (less transaction costs).
Yes, the maximum loss potential is $4.25 for either the put spread or the call spread, so you haven’t increased your dollar risk by selling both spreads. But, you have increased the risk of loss in terms of where the market can go for that loss to happen. For instance, if you had sold just the put spread, then the stock could go to $170 at expiration without you worrying. Or, if you sold just the call spread, the stock dropping to $140 wouldn’t be an issue.
The iron condor requires the market to stay within a range of prices. How might one decide on the range, or the strike prices, for a given underlying? Figure 1 shows an iron condor with 10 days until expiration. The light gray portion in the middle of the risk graph highlights the “one standard deviation” expected range based on the current level of the implied volatility. The phrase "one standard deviation" is a fancy way of saying that, based on current option prices, it is expected that about 68% of the time the stock will stay within this range until expiration. It’s an expectation. In the real world anything can happen. Implied volatility is the estimated volatility of the stock's price.
With this example, the high-side short strike (the short call) is outside of this expected range. The low-side short strike (the short put) is near the edge of the expected range, with the expiration breakeven price of the stock right at the edge. If the stock were to stay within this range, then this iron condor wouldn’t lose. Of course, if the stock does move outside this range, then the iron condor will start to lose money, eventually losing the maximum if it moves below $145 or above $165.
If you think the market is going to move, then a basic short vertical spread might be the strategy to go with. But when you think a market will stay within a range, consider using an iron condor to bring in additional premium without increasing your dollar risk.
Want more on Iron Condors? Join Swim Lessons on May 18th at 10:30 AM CT as Scott Connor and I dive in!
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