In our previous two blogs, we went through both bullish and bearish strategies, Bull Call, and Bear Put spread as per directional stance. But what if your view is neutral and you expect that the index or stock you want to trade will move in a narrow range? Enter, Iron Condor.
An Iron Condor is a multi-leg, risk-defined and neutral view strategy with limited profit and loss potential. The strategy consists of two call options (one short and one long) and two put options (one short and one long), all with the same expiration date and of the same underlying.
The Iron Condor can be deployed in two ways:
1. Short Iron Condor: It is a strategy in which a trader receives the net premium after deploying all the four options. As a net credit strategy, the trader expects the underlying to trade in a range so that at expiry all the options contracts expire worthless and he or she can pocket the entire premium collected. The short Iron Condor is the classic version of this strategy which is often deployed by option traders
2. Long Iron Condor: It is a net debit strategy in which traders expect the underlying to make a significant move in either direction to make a profit.
In this blog, we will be focusing on the short Iron Condor Strategy.
Jargon Alert: 📢
1) Multi-leg: means selection of two or more strikes to enter a trade. Simply put, consider one leg of Iron Condor strategy as one strike price. To deploy the Iron Condor you need 4 strikes.
2) Short and Long: Let’s simplify the long and short of both calls and puts as per the view on the market.
a) Long Put: You buy it when the view is bearish
b) Short Put: You sell it when the view is bullish or range-bound.
c) Long Call: You buy it when the view is bullish
d) Short call: You sell it when the view is bearish or range-bound.
How to deploy a Short Iron Condor strategy? 📊
An Iron Condor works just like a short strangle with further out-of-the-money long options purchased which acts as a hedge or a protection to the sold option strikes.
In this strategy, a trader sells an OTM ( out-of-the-money) put and call options and buys far OTM put and call options. As mentioned above, the far OTM options are bought to protect the short put and call strikes.
Strike 1 - Buy a far OTM put option
Strike 2 - Sell an OTM put option
Strike 3 - Sell an OTM call option
Strike 4 - Buy a far OTM call option
Iron Condor Example
Let’s understand this strategy with the help of an example of the NIFTY 50 index. As of 6 September, the NIFTY 50 is trading at 17,688. You believe that the index is likely to stay in the range of 200 to 250 points before the expiry of the weekly contracts, which is on 8 September.
As we look at the data of the NSE option chain for the 8 September expiry, the 17,600 put and 17,800 call options marked in red are trading for a premium of ₹71 and ₹63. These are the OTM strikes 2 and 3, which we discussed in the table above. Similarly, the strikes highlighted in the colour black are far OTM strikes 1 and 4. The far OTM call 17,850 and 17,550 put option strikes are trading for a premium of ₹45 and ₹57, respectively.
To further simplify things, this is how the final Iron Condor order placement will look like:
As shown in the table above, the net premium received after deploying this strategy will be ₹32. We arrived at this number by subtracting the net premium/money received from the net premium paid.
(71+63)- (57+45)= 32.
Iron Condor Payoff diagram
As you can see in the payoff graph above, the 200 points difference between the sold strikes 2 and 3, i.e. 17,800 – 17,600, highlights the Iron Condor's body. To understand the body and wings of the Iron Condor, let's deep dive into this strategy's maximum profit and maximum loss potential.
Good to know
Break even point🚦
In this strategy, you expect the index to trade and close in an expected range to make the maximum profit. So, the strategy will have two breakeven points, one upper and one lower.
Breakeven point 1: On the lower side, if the NIFTY 50 index slides and closes below the 17,568 mark at expiry, the strategy will make a loss. We arrived at this value by subtracting the short put option strike (17,600 PE) from the net premium received, i.e. 17,568. (17,600-32)
Breakeven point 2: On the higher side, if the NIFTY 50 index moves above the 17,832 mark at expiry, the strategy will make a loss. We arrived at this value by adding the net premium paid to the short call option strike (17,800 CE), i.e. 17,832 (17,800+32)
Note: While deploying the Iron Condor, remember that the buy strikes spreads should be equidistant on both sides. It means the difference between the sell and buy strikes should be the same. For eg: Strike 4-Strike 3= 50 (17,850-17,800) and Strike 2- Strike 1= 50 (17,600-17,550)
Maximum Profit
The net premium received after deploying an Iron Condor is essentially the maximum profit of the strategy. In this case, the net premium received is ₹32. It is important to note that time decay plays a significant role in generating profit. The sold pair of options expire worthless, thus enabling the trader to collect the entire premium.
Moving to the maximum profit, if the NIFTY 50 index closes within the 200-point range (17,600 and 17,800) at expiry, the strategy will make maximum profit. As you can see in the payoff graph above, this range denotes the body of the Iron Condor. So, the maximum profit a trader can make in this strategy is ₹1,600. It is to be noted that the lot size of an options contract for the NIFTY 50 index is 50.
Max profit = net premium received * lot size (32* 50 = ₹1,600)
The strategy will still make some profit beyond the 200 price range- as long as the index stays within the lower and the upper range of the breakeven points. Simply put, the strategy will be profitable if the NIFTY 50 index stays between 17,568 and 17,832.
Maximum Loss
Since we are aware that the Iron Condor is a risk-defined strategy, the loss is not only limited but also known beforehand. If we roll back to our example of the NIFTY 50 index, the strategy loss will be limited to the wings on both sides of the payoff graph.
The wings are the identical spreads of 50 points which we discussed for both long call and long put strikes while calculating the breakeven points. So, if the NIFTY 50 index makes any sharp move on the higher or lower front, the strategy's loss will be restricted to ₹900, i.e. (32*50).
Maximum loss if NIFTY 50 index makes a sharp downward move= (spread i.e. (strike 2 – strike
1)– net premium received) * lot size
Spread= Strike 2- Strike 1= 50 (17,600-17,550)
Net premium paid= ₹32
Maximum loss = ₹900 (50-32*50)
Maximum loss if NIFTY 50 index makes a sharp upward move = (spread i.e. (strike 4 – strike
3) – net premium received) * lot size
Spread= Strike 4- Strike 3= 50 (17,850-17,800)
Net premium paid= ₹32
Maximum loss = ₹900 (50-32*50)
What works in favour
- Time decay
After deploying an Iron Condor strategy, you receive the net premium (credit). So, every day as contracts near expiry, the net premium received keeps shrinking as far as the underlying stays in a defined range, which means that the time decay works in favour of the strategy.
- Fall in implied volatility
The Iron Condor strategy benefits from a decline in implied volatility. The strategy is initiated when the implied volatility is higher and is expected to fall closer to the expiry.
- Risk defined strategy
In an Iron Condor, a trader is aware of the loss that he or she will incur well in advance if the view goes wrong. The strategy offers a fixed level of risk on the capital deployed. If we refer to the example above, the maximum loss of a trader is restricted to ₹900.
What works against
- A sharp movement in the underlying
After deploying the Iron Condor, if the underlying makes a sharp move on either side, then the strategy will make a loss. Knowing this, it is advisable to deploy the Iron Condor strategy when you believe the underlying will remain in a narrow range till the expiry of the contract.
- Limited profit potential
The Iron Condor strategy involves buying two option contracts to cap the risk of the trade. So, by purchasing the options, the trader essentially pays the premium from pocket. Thus, the net inflow after receiving and paying the premium is the maximum profit of the strategy.
- Higher cost to deploy the strategy
Since Iron Condor is a four-leg strategy, the execution cost of the trade is slightly higher than the strategies that involve fewer contracts.
- Complex than the spread strategies
As a beginner in options, Iron Condor may come across as a complex strategy that involves four options contracts. Before initiating an Iron Condor, a trader should fully understand the role of all the option strikes involved. If the timing and the view about the underlying is incorrect, then the strategy can make a loss. So, the bottom line is that an Iron Condor can be an extremely useful options strategy if utilised well as per the behaviour and movement of the underlying. Want a pre-curated Iron Condor strategy and decode the matrix behind it? Upstox has got you covered. Upstox has introduced Ready-made Option Strategies, a safer way to trade in NIFTY 50 and BANK NIFTY options. Click here to know more.