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Option Basics: the Iron Condor

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We have written in the past about vertical spreads being the building blocks for more complex option strategies. In this article we will discuss the Iron Condor, which is comprised of two credit spreads: the Put credit spread (or Bull Put spread); and the Call credit spread (or Bear Call spread).

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The Iron Condor is a defined risk non-directional strategy that is often employed for underlyings that have high IV (implied volatility) or high IV rank (greater than 50%). This typically occurs just before an earnings announcement in which a large move is possible, but the direction is unknown.

As a review, a credit spread is a vertical spread in which two options for the same underlying asset (stock, index, future, etc.) and same option chain (Weekly or Monthly), are bought and sold concurrently. To form a credit spread (which brings premium into your account), you sell one option with a strike that is closer to ATM (at the money), or closer the current price of the underlying, while buying an option with a strike that is further OTM (out of the money), or further away from the underlying's current price.

For example (see charts), looking at the SPXPM (S&P500 index options) monthly FEB 14 option chain with 48 DTE (days to expiration) we have the following setup:

Sell 1 FEB 14 Call 1925, Buy 1 FEB 14 Call 1930 for a $0.30 premium
Sell 1 FEB 14 Put 1735, Buy 1 FEB 14 Put 1730 for a $0.60 premium

The total premium is $90 (100 x ($0.30 + $0.60)) which is the maximum profit that can be made; and the maximum loss (or Risk Capital) is $410 (100 x (1735-1730) + $90) which is also the Buying Power Reduction (or margin). The ROC (return on capital) is: 21.95% ($90 / $410).

The advantage of the Iron Condor is that the max loss actually drops (return on capital improves) compared to either credit spread, due to increased premium. Remember, the calculation for the max loss is:

max loss = strike price of Short Put - strike price of Long Put - total premium received
or
max loss = strike price of Long Call - strike price of Short Call - total premium received

Since you can only have a loss on either side of the Iron Condor at expiration (not both), the calculation of Risk Capital is based on the width of the spread less premium received (plus commissions).

There is a tradeoff for the additional premium received by the Iron Condor (vs. a single credit spread), and that is the reduction in POP (probability of profit). Theoretically at 1 SD (standard deviation), the POP of either credit spread is approximately 84%; for the Iron Condor the POP drops to approximately 68%. We can see from the Charts that the POP for each credit spread is: Bull Put = 85.89%; Bear Call = 85.08%. For the Iron Condor, the POP is 71.86% (see Probability Analysis chart).

Could we have done better on this trade? Yes; as IV and IV Rank increase, the strikes will move further OTM and the premium will increase. With the SPXPM example (see Options Statistics chart), the IV was 13.33% and the IV Rank was 44%.

In conclusion, if you have no directional opinion of the underlying and IV Rank is high, an Iron Condor is a viable strategy that brings in more premium with no additional Risk Capital or margin; the tradeoff is POP, which is lowered.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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