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We recently finished a series of articles covering a straddle strategy, so it is time to start a new Real-World series on a new strategy. For the next six weeks we will be discussing the use of an iron condor strategy. This week we will detail the set up of the strategy, showing how it works and what we are looking for in the underlying security. Next week we will talk about searching for these trades and set up a mock trade that we can follow it from week to week.

An iron condor sounds like a complex trade, but it isn't as tough as it sounds. This strategy is akin to the butterfly and iron butterfly and condor strategies. All these strategies are neutral in nature, meaning they profit when the underlying stays within a given range. An iron condor is the combination of a bull put spread and a bear call spread. All options use the same expiration, normally the front month. This is because the trade benefits from time decay and we do not want to give the stock too much time to move out of its profit range.

Normally, an iron condor will see more risk than reward, but the odds of the stock staying in the profit zone is usually quite good. Below is a generic risk graph of an iron condor:


Figure 1: Iron Condor Risk Graph

An iron condor is set up by buying a lower strike put, selling a higher strike put, selling a higher strike call and buying a higher strike call. Unlike a butterfly or regular condor, an iron condor uses both calls and puts and results in a credit. The max profit is the credit received, but traders need to be aware of commissions since four different options need to be used. For example, if XYZ is trading at 57 and is expected to remain in a range between 55 and 60, a trade could set up an iron condor by buying a 50 put, selling a 55 put, selling a 60 call and buying a 65 call. If XYZ does indeed close between 55 and 60 at expiration, all four options would expire worthless, leaving the trader with the full credit. Let's use a more detailed example to show how the breakeven points and max loss is figured.

XYZ @ 57
Buy 50 Put @ 0.50
Sell 55 Put @ 1.50
Sell 60 Call @ 1.00
Buy 65 Call @ 0.40

Credit - (1.50+1.00) - (0.50+0.40) = 1.60 or $160 per iron condor
Max Risk - Difference in strikes (5 points) - credit (1.60) = 3.40 or $340 per iron condor
Downside Breakeven - Short Put Strike (55) - credit (1.60) = 53.40
Upside Breakeven - Short Call Strike (60) + credit (1.60) = 61.60

The above example would create a trade that would make some sort of profit as long as XYZ closes at expiration between 53.40 and 61.60. The ideal situation is to find a stock that has options showing high IV, but that is expected to close within a range. The higher the IV of the sold options, the better than reward to risk ratio, but this can also mean higher odds of the stock moving sharply.

When deciding between a butterfly, a condor and an iron condor, it all depends on the reward-to-risk ratio and the profit zone. The condor and iron condor will usually have a very similar reward-to-risk ratio, but it is nice not to have to worry about doing anything with the trade if the underlying remains in between the max profit zone. Many traders prefer to use index options for iron condors because they tend to see less volatility than individual stocks. This can increase the odds of a profit being made, but will also lessen the amount of profit and increase the total risk.

Next week, we will go into more detail about how to find good iron condor trades. We will also choose a security and enter a mock iron condor trade. We will then follow that trade until expiration to show how the strategy works and we will discuss the exit strategies that can be used. In the meantime, feel free to ask any questions and to make comments on my forum, which you may access through "Ask the Traders" from the Discussion board on the homepage of Optionetics.com. We can all learn from each other, so please don't be afraid to ask any questions you have.

Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site

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