Iron condor is a non-directional structured option strategy and it is comprised of 2 vertical spreads: 1 call spread and 1 put
spread amounting 4 options in total (2 call and 2 put).
An iron condor allows you to profit as long as the underlying price stays in a price range. So, it is quite useful during times when you expect limited volatility and flat market conditions.
Although it might resemble to the covered call strategy initially there are some main characteristics of iron condor that make it different than a covered call or pmcc strategies.
Mainly, iron condor has loss profile on both directions but limited. Loss profile occurs on both ends unlike the covered call which has capped profit profile on one end and limited loss profile with the whole value of the option on the other end (at least theoretically).
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Iron Condor vs PMCC |
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Iron Condor |
PMCC |
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1 long call + 1 short call |
1 long call + 1 short call |
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Limited loss (with a price level) |
Loss limited (with full investment) |
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Non-directional profit |
Up or flat market is favorable |
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Slightly more complicated |
Slightly less complicated |
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Commissions for 4 options can be high |
LEAPS can have a high bid-ask spread |
EXAMPLE :
Underlying SPY trading at $265
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Iron Condor Strategy (@SPY) |
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Long put |
Short put |
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Strike $245, term: 3 months |
Strike $255, term: 3 months |
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Price: $3.00 |
Price: $4.80 |
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Long call |
Short call |
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Strike $285, term: 3 months |
Strike $275, term: 3 months |
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Price: $1.25 |
Price: $4.00 |
Long put: Strike; $245, maturity: 3 months ahead (option trading at $3.00)
Short put: Strike; $255, maturity: 3 months ahead (option trading at $4.80)
Short call: Strike; $275, maturity: 3 months ahead (option trading at $4.00)
Long call: Strike; $285, maturity: 3 months ahead (option trading at $1.25)
Premium from put and call sales: $4.80 + $4.00 = $8.80
Expense from put and call sales: $3.00 + $1.25 = $4.25
Net result from proceedings: $8.80 – $4.25 = $4.55 (Also shows maximum potential
profit)
Please note how puts are structured to have out of money strikes with the long put being deeper out of money than the short put which allows the put sold to be more expensive and trap a profit margin in that range. Similarly, you can see how calls have also out of money strikes with the short call having a more favorable strike (closer to at the money or underlying price) hence trapping a
profit here as well.
The result is limited potential profit at an underlying price range.
Scenario 1: Underlying stays at $265 on the expiry date. In this scenario, all the options involved expire worthless and $4.55 profit from the difference between long and short option premiums is realized.
Scenario 2: Underlying falls to $245 on the expiry date. In this scenario, all the options except the shorted put with $255 strike expire out of money. The short put will result in a loss of $10 ($255 – $245) since it is in he money on expiry. When we subtract the premium profit of $4.55 this will give the net loss from the strategy: $10 – $4.55 = $5.45 (maximum possible loss)
Scenario 3: Underlying falls below $245 on the expiry date. In this scenario, we can demonstrate why Scenario 2 created the maximum loss. At any value underlying price goes below $245 our long put position will start to be in the money and offset the further losses that the short put will create. So, let’s say underlying price falls all the way to $200, our short put will be in the money $55 ($255-$200) while out long put will also be in the money $45 ($245 – $200) offsetting the losses after $10 loss that occurs when long put option is at the money. So, loss is again $10 – $4.55 = $5.45
Scenario 4: Underlying rises to $275 on the expiry date. In this scenario, all the options will again be out of the money resulting in $4.55 maximum profit once again.
Scenario 5: Underlying rises to $285 on the expiry date. In this scenario, maximum loss will occur one more time since only short call will be in the money with $10 ($285 – $275). And when we subtract our profits from premium differences $10 – $4.55 = $5.45.
Scenario 6: Underlying rises above $285 on the expiry date. In this scenario, like Scenario 3, long call option will kick in and start to offset the losses from the short call position and maximum possible loss will remain the same at $5.45
Here is a visualization of the Iron Condor example.
Notice how strategy profits between $255 and $275 values of the underlying price? Also, you can see that below $245 and above $285 loss become a flat line, meaning maximum loss is reached.
You might realize that although looking more complex than covered calls initially, iron condors have a more straightforward P&L profile that in the end makes comprehension and working with them easier than it initially thought.
Another reason for this phenomenon is because it is a combination of 2 spreads on both ends of the price movement unlike the covered call which is a capped profit profile on one end and changing loss profile on the other (diverging to zero as the underlying price keeps falling).
Asymmetric Iron Condor
If you have a good understanding of options and structured option strategies by now you might have had a thought about the iron condor example. The example we saw had equal strike intervals on both ends which made the profit and loss profile look symmetrical.
EXAMPLE :
What if we designed it in a way that one of the spreads had different characteristics or boundaries? This is possible by adjusting the strike prices of either spread.
Let’s see an example where the call spread is looking different.
Underlying SPY trading at $265
Iron Condor Strategy (@SPY) | |
Long put | Short put |
Strike $245, term: 3 months | Strike $255, term: 3 months |
Price: $3.00 | Price: $4.80 |
Long call | Short call |
Strike $290, term: 3 months | Strike $270, term: 3 months |
Price: $0.65 | Price: $6.47 |
Long put; Strike: $245, maturity: 3 months ahead (option trading at $3.00)
Short put; Strike: $255, maturity: 3 months ahead (option trading at $4.80)
Short call; Strike: $270, maturity: 3 months ahead (option trading at $0.65)
Long call; Strike: $290, maturity: 3 months ahead (option trading at $6.47)
Premium from put and call sales: $4.80 + $6.47 = $11.27
Expense from put and call sales: $3.00 + $0.65 = $3.65
Net result from proceedings: $11.27 – $3.65 = $7.62 (Also shows maximum potential
profit)
You may realize that potential maximum profit increased compared to the previous example. However, this will come with a cost. We will realize that potential maximum loss has also increased on the call spread side. So, the Scenario 1-2-3 remains unchanged where the underlying price falls or stays flat. Let’s look at when the underlying price increases in Scenarios 4-5-6.
Scenario 1: Underlying stays at $265 on the expiry date. In this scenario, all the options involved expire worthless and $7.62 profit from the difference between long and short option premiums is realized.
Scenario 2: Underlying falls to $245 on the expiry date. In this scenario, all the options except the shorted put with $255 strike expire out of money. The short put will result in a loss of $10 ($255 – $245) since it is in the money on expiry. When we subtract the premium profit of $4.55 this will give the net loss from the strategy: $10 – $7.62 = $2.38
Scenario 3: Underlying falls below $245 on the expiry date. In this scenario, we can demonstrate why Scenario 2 created the maximum loss. At any value underlying price goes below $245 our long put position will start to be in the money and offset the further losses that the short put will create. So, let’s say underlying price falls all the way to $200, our short put will be in the money $55 ($255-$200) while out long put will also be in the money $45 ($245 – $200) offsetting the losses after $10 loss that occurs when long put option is at the money. So, loss is again $10 – $7.62 = $2.38
Scenario 4: Underlying rises to $270 on the expiry date. In this scenario, all the options will again be out of the money resulting in $7.62 maximum profit once again.
Scenario 5: Underlying rises to $290 on the expiry date. In this scenario, maximum loss will occur one more time since only short call will be in the money with $20 ($290 – $270). And when we subtract our profits from premium differences $20 – $7.62 = $12.38.
Scenario 6: Underlying rises above $290 on the expiry date. In this scenario, like Scenario 3, long call option will kick in and start to offset the losses from the short call position and maximum possible loss will remain the same at $12.38.
As you can see, by widening the spread between call
options, we have created a higher maximum profit profile of $7.62. However, on
the call option side (as underlying price increases) potential maximum loss
also increased to -$12.38.
This time, you can see the iron condor is oppositely skewed in this graphic. Higher loss occurs on the lower side of the underlying price and this is possible by increasing the spread between strike of the put options.
The power of creating such tailored strategies with options allows investors to invest in their insight much more precisely than
conventional investment techniques. For instance, if you were to expect more downside than upside you could increase your profit by increasing the upside loss potential. Or similarly, if you see more upside probability in future compared to downside due to market conditions, cycles, fundamentals, timing, politics or any other reason you might have, you could design the iron condor asymmetric in a way that the put spreads are larger than the call spreads.
