Iron condors

Like butterfly spreads , iron condor strategies involve all four option types and initially seem complex. We’ll cover the following in this chapter:

• Long iron condors
• Short iron condors

Long iron condors

Let’s dive right in and look at an example of a long iron condor:

Short 1 ABC Feb 50 put at $1
Long 1 ABC Feb 55 put at $2
Long 1 ABC Feb 60 call at $3
Short 1 ABC Feb 65 call at $1

ABC’s market price = $58

The “heart” of this strategy is similar to a long strangle. As a reminder, a long strangle involves purchasing a call and put, both of which are “out of the money” (maintain no intrinsic value). A long strangle would exist if the long 55 put and long 60 call were extracted together. A $500 total debit would be incurred if the investor only traded these two contracts. The sale of the 50 put and 65 call bring in $200 in premiums, reducing the overall cost of this long iron condor to $300.

Maximum gain
Like a long strangle, the investor is seeking volatility. Best-case scenario, ABC’s market price falls to $50 or rises to $65. If ABC falls to $50, the long 55 put is “in the money” by $5, or $500 overall ($5 x 100 shares per contract). Netting this intrinsic value gain against the initial $300 debit results in a $200 gain. If ABC rises to $65, the long 60 call is “in the money” by $5, or $1,000 overall. Netting this intrinsic value gain against the initial $500 debit also generates a $200 gain. Therefore, $200 is the strategy’s maximum gain in either scenario.

The two short options limit the investor’s gain potential. If ABC’s market price falls below $50, the long 55 put’s intrinsic value gains are offset by the short 50 put’s intrinsic value losses. If ABC’s market price rises above $65, the long 60 call’s intrinsic value gains are offset by the short 65 call’s intrinsic value losses. In either circumstance, the investor makes the maximum gain of $200.

Breakeven
The investor must obtain a return equal to the $300 initial net debit to break even. Long iron condors have two breakeven points because a return can be made in either direction (in a bear or bull market). If ABC’s market price falls to $52, the long 55 put is $3 “in the money,” providing an intrinsic value gain of $300 ($3 intrinsic value x 100 shares per contract). If ABC’s market price rises to $63, the long 60 call is $3 “in the money,” providing an intrinsic value gain of $300. Either scenario offsets the original $300 net debit, so the investor will break even at $52 or $63.

Maximum loss
The investor loses when the market stays flat. All contracts will assumptively expire with no intrinsic value if ABC’s market price remains between $55 and $60. If this occurs, the investor is stuck with their initial net debit, resulting in a $300 maximum loss.

Short iron condors

Let’s dive right in and look at an example of a short iron condor:

Long 1 XYZ Dec 30 put at $1
Short 1 XYZ Dec 40 put at $3
Short 1 XYZ Dec 50 call at $3
Long 1 XYZ Dec 60 call at $1

XYZ’s market price = $44

The “heart” of this strategy is similar to a short strangle. As a reminder, a short strangle involves selling a call and put, both of which are “out of the money” (maintain no intrinsic value). A short strangle would exist if the short 40 put and short 50 call were extracted together. A $600 total credit would be obtained if the investor only traded these two contracts. The purchase of the 30 put and 60 call cost $200 in premiums, reducing the overall credit of this short iron condor to $400.

Maximum gain
Like a short strangle, the investor is seeking a flat market. In the best-case scenario, XYZ’s market price stays between $40 and $50. Between these two price points, all contracts are “out of the money” and will expire worthless. The investor would keep the $400 net credit with no further action taken. Therefore, $400 is the strategy’s maximum gain.

Breakeven
The investor must lose an amount equal to the $400 initial net credit to break even. Short iron condors have two breakeven points because a loss can be incurred in either direction (in a bear or bull market). If XYZ’s market price falls to $36, the short 40 put is $4 “in the money,” providing an intrinsic value loss of $400 ($4 intrinsic value x 100 shares per contract). If XYZ’s market price rises to $54, the short 50 call is $4 “in the money,” providing an intrinsic value loss of $400. Either scenario offsets the original $400 net credit, so the investor will break even at $36 or $54.

Maximum loss
The investor loses when the market is volatile. Worst-case scenario, XYZ’s market price falls to $30 or rises to $60. If XYZ falls to $30, the short 40 put is “in the money” by $10, or $1,000 overall ($10 x 100 shares per contract). Netting this intrinsic value loss against the initial $400 credit results in a $600 loss. If XYZ rises to $60, the short 50 call is “in the money” by $10, or $1,000 overall. Netting this intrinsic value loss against the initial $400 credit also generates a $600 loss. Therefore, $600 is the strategy’s maximum loss in either scenario.

The two long options limit the investor’s loss potential. If XYZ’s market price falls below $30, the long 30 put’s intrinsic value gains are offset by the short 40 put’s intrinsic value losses. If XYZ’s market price rises above $60, the long 60 call’s intrinsic value gains are offset by the short 50 call’s intrinsic value losses. In either circumstance, the investor is subject to a maximum loss of $600.