The Iron Condor option trading strategy takes advantage of the low market volatility. With limited risk involved, you have the probability of winning a nice profit. As a directionally neutral strategy, iron condor trading does not require you to forecast the market direction.
The objective of the iron condor options is to allow traders to profit if the underlying instrument is not moving that much by expiration date. Don’t let the name of the strategy intimidate you. By the end of this iron condor trading tutorial, you’ll be an expert in trading iron condors for a living.
In options trading, the time element is very important. Time premium is sucked out of the market every day. If you buy options, you’re constantly fighting this time decay, also known as theta decay. When trading options, it's critical to have a grounded understanding of the time value.
Instead of fighting the time decay, we prefer to let it work for us and generate some profit out of it.
Next, we’re going to teach you what an iron condor is and share one of our favorite iron condor strategies. You can start trading with it immediately and put time decay in your favor, even with a small account.
Iron Condor Options
The first element of an iron condor consists of selling an out of the money put and, at the same time, selling an out of the money call. We do this with the hope that between now and the expiration the stock price we will trade between the strikes and the options we sold will go to zero.
If this is the case we will keep the entire price we sold these options for. Like naked forex trading, short naked options have a lot of risk and can even require a lot of capital. In order to construct an iron condor; we’re also going to buy a further out of the money put and simultaneously buy a further out of the money call for protection.
Now, these four different options contracts as a group are called an iron condor.
Note* each of the four options have the same expiration date but different exercise prices.
To check if you constructed the iron condor options the right way you need to have two selling options and two buying options.
Basically, iron condor options is a four-legged trade where you’re selling out of the money put spreads and simultaneously selling out of the money call spread!
So, the iron condor can also be seen as a combination of two vertical spreads -
- A bull put spread
- A bear call spread
So, how does it work in practice? Let's show you how to take advantage of calls and puts using this strategy.
Iron Condor Option Trading Strategy
We’re going to show you by walking you through an iron condor example.
Let’s assume that ABC stock is trading at $55 per share. In the figure below you can see a hypothetical option chain of ABC stock. These options have 30 days until they expire.
For the purpose of this example we’re going to sell the $65 OTM calls for $2 and we’re also going to sell the $45 OTM puts for $2.Our idea is that the stock will stay in between these strikes and the options we sold will expire worthless.
However, since naked options theoretically have unlimited risk, we need to buy some protection and construct our iron condor.
In this regard, we also need to buy further out of the money options like buying the $70 OTM calls for $1 and simultaneously buy the $40 OTM puts for $1.
The downside is that you need to keep up with all these individual option trades.
Let’s assume the time has passed and we’re near the 30 day expiration. During this time period the stock hasn’t moved much and just kind of consolidates in a tight range. As we’re near the expiration, these options remain out of the money and the price of each option gradually goes to zero.
If all of these options are worthless, how can we profit then?
Well we make a profit of $200 from our $65 OTM calls and another additional $200 from our $45 OTM puts. Because we’re short these options and they are now at zero, we collect the credit. And since the options expire is worthless, we got to keep that credit.
All good up until now!
However, we also lost some money on the options we bought as protection. We realized a loss of $100 from our $70 OTM calls and another additional loss of $100 from our $40 OTM puts. Since we bought these options and they expired worthless we lose the premium.
Adding all of the PnL together it totals to a net profit of $200. We’ve made $400 on our buy options and lost $200 on the sell options.
The profit/loss diagram of an iron condor trade is similar to a large bird with wings. The short strangle vs. iron condor have the same characteristic.
Iron condor trading requires the stock price to stay within a specific price range. The long OTM puts and calls are simply bought as protection. It’s the same as we pay for car insurance in case we crash our car.
The iron condor maximum profit can also be calculated with the following formula:
Max Profit = Net Premium received – Commissions Paid
While the iron condor maximum loss can be calculated using the following formula:
Max Loss = Strike Price of Long Call - Strike Price of Short Call -
Net Premium Received + Commissions Paid
How to adjust the iron condor trading?
We’re going to share with you some trading tips to be able to trade iron condors for a living.
Iron Condor Trading Tips
When it come to iron condor trading, timing the market and strike price selection are critical if you want to profit from iron condor. Luckily for us we can use the stock price chart to define the trading price range.
Remember that we can only profit from the iron condors if we have a range bound stock.
The best iron condor trading trick is to setup the strike prices on the outside of that price range. This will give us a higher probability of success rather than just randomly picking up the strike prices.
In the figure below we can note Twitter shares trading in a price range. Simply choose the strike prices that are outside of the range price.
When it comes to timing an iron condor we want to start with less than 30 days expiration. Because the time decay speeds up as closer as we get to the expiration date we want to use that to our advantage.
Conclusion – Iron Condor Trading
The iron condor option trading strategy is designed to produce a consistent and small profit. When we do iron condor trading we have to keep in mind that the potential loss is always bigger than the generated profit. But even then the loss is capped to a certain amount.
Successfully trading the iron condor options requires choosing the proper strike prices and the proper stocks. The best stocks for iron condor are the one that trade within a specific price range. The further apart are these strike prices the higher the probability that by the expiration date the underlying instrument will trade between the strike prices.
In the end it all comes down to the market volatility. If you believe there is a chance the market will experience low volatility then you have the right environment to deploy iron condor trading to limit your risk.
Thank you for reading!
Check out a similar strategy you can use to trade binary options here.
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