Chapter 9

Iron condor option strategy

Up until now, we have discussed strategies that can be deployed when traders believe a security will move up or down. We have also discussed what strategy works if one is uncertain about the direction, but believes the security could be volatile before expiry. But what happens when markets are flat and one does not expect any volatility around expiry? The Iron condor is your answer. Think of it as a more complex short straddle - but one where the losses are limited. Read on to understand what it is and how to construct it. 

Why would you use this? 

A trader will enter into an Iron Condor option strategy if they believe that the underlying will not be volatile during the period prior to expiration. This strategy is essentially a hedged, short strangle. We learned about short straddles earlier. The biggest drawback to that strategy was the potential for unlimited losses. With an iron condor, the strategy is constructed so that the maximum loss is fixed.

This trade works best when the underlying is more volatile prior to entering the trade and then becomes less volatile during the life of the options. Also, the trader isn’t required to have a specific forecast of market direction, but the trade will be successful if the underlying security doesn’t move.

How do you construct it? 

An Iron Condor is the most complicated strategy that we will discuss. This is a four-leg strategy and consists of buying a call and put as well as selling a call and put. We will break this down into two parts to help you understand this better: the short strangle and the hedge. 

As you have seen earlier, in a long strangle, a trader purchases a put option at a particular strike price, usually one that is below the current underlying price. The trader also purchases a call option at a strike price that is above the put option’s strike price. Often the call option strike price is above the current underlying price. 

To construct a short strangle, the trader does the exact opposite. They would sell these options instead of buying them. In the two illustrations below, you can see the payoff differences between the long strangle and short strangle are mirror images.

Illustration 1

Let’s walk through how we would implement this. Using the data in illustration 2, we would short a strangle by selling the 390-strike put and the 400-strike call option. By doing this, the trader would receive 4.42 in premium from the short 390-strike put and 3.94 in premium from the short 400-strike call. The total premium received from this part of the trade is 8.36.

Looking at the short strangle payoff above, the ‘red’ sections on the left and right represent possibilities of significant loss for the trader if the underlying moves into these areas. The benefit of the iron condor is limiting the downside risk in these ‘red’ sections. This is done by purchasing a put at a strike lower than the sold put and also purchasing a call at a strike higher than the sold call.

Let’s walk through how we would implement this. Using the data in illustration 2, we would short a strangle by selling the 390-strike put and the 400-strike call option. By doing this, the trader would receive 4.42 in premium from the short 390-strike put and 3.94 in premium from the short 400-strike call. The total premium received from this part of the trade is 8.36. 

To complete the Iron Condor, the trader would also purchase the 385-strike put and 405-strike call options. These long options would act as a hedge thus capping the downside for the strategy. The 385-strike put costs 3.06 and the 405-strike call costs 2.22. The total cost of the long options is 5.28. The net premium received by the trader for executing this Iron Condor with 390-395-400-405 strikes is 3.08.

Illustration 2

What is the maximum profit? 

The maximum profit occurs when the underlying closes in between the two shorted strike prices. This means that at expiry, none of the options have intrinsic value and the trader retains all of the initial premium collected by executing the Iron Condor. In this example, the maximum profit is 3.08.

Key Formulae

• Iron Condor Profit = Short Call Profit + Short Put Profit + Long Call Profit + Long Put Profit
  • Short Call Profit = Premium Received – Max(0, Underlying Price – Strike Price)
  • Short Put Profit = Premium Received – Max(0, Strike Price – Underlying Price)
  • Long Call Profit = Max(0, Underlying Price – Strike Price) – Option’s Cost
  • Long Put Profit = Max(0, Strike Price – Underlying Price) – Option’s Cost

What is the break-even point? 

An Iron Condor has two break-even points. The first break-even point is the short put strike price minus the premium received to enter the strategy. The second break-even point is the short call strike price plus the premium received to enter the strategy. 

Key Formulae

• Iron Condor Break-even Point #1 = Short Put Strike – Net Premium Received
• Iron Condor Break-even Point #2 = Short Call Strike + Net Premium Received

Similar to the short strangle and short straddle strategies, the break-even point is not the point where the Iron Condor becomes profitable. This being a net credit position, or one that receives a net premium upon entering the strategy, the break-even point is where we have lost the premium received due to market movements. At this point, our position turns negative. 

In illustration 3 below, you can see two sections that are shaded red: one to the left of the 390-strike price and one to the right of the 400-strike price. Since the total premium received is 3.08 to enter this example iron condor, the two break-even points would be 386.92 (390 – 3.08) and 403.08 (400 + 3.08).

Illustration 3

What is the maximum loss? 

The maximum loss of an Iron Condor is limited due to the purchase of the long call and put options that hedge against the potential losses of the short call and put options. 

The maximum loss occurs when the underlying is at one of two positions: 

• When the price of the underlying is less than the strike of the long put at expiry 
• Or when the price of the underlying is above the strike of the long call at expiration. 

In our example, if the underlying expires with a price less than 385 (the strike of the long put) or greater than 405 (the strike of the long call), then the Iron Condor will have a maximum loss.

The maximum loss is the same regardless whether the underlying expires below the long put strike or above the long call strike. The loss amount is calculated by taking the difference between the break-even point and the associated strike for the maximum loss. 

That is a bit technical but here is an example. To understand the loss if the underlying price expires below the long put strike, then you would use the lower break-even point. In our example, the lower break-even point is 386.92. The long put strike is 385. The maximum loss when the underlying is at or below 385 is the difference between 386.92 and 385 which is 1.92. 

Alternatively, we could look at the upper break-even point. In our example, the upper break-even point is 403.08. The long call strike is 405. The maximum loss when the underlying is at or above 405 is the difference between 405 and 403.08. This difference representing the maximum loss is also 1.92.

Iron Condor Scenarios using Historical Data

Let’s discuss a few examples using real market data to understand the opportunities and risks associated with iron condors.

Scenario 1 – Underlying stays between the break-even points

The Situation:

• The trader believes the Nifty won’t move from its current price over the next week. Currently, the Nifty is trading at 17,576.85.
• The trader decides to enter into an Iron Condor strategy to take advantage of the benefits of a short strangle while reducing the downside risk. The table below lists the four options and associated strike prices. The ‘debit’ represents a cash outlay or a cost to the trader. The ‘credit’ represents a cash inflow or premium received by the trader.
  

• The total net premium received by the trader is 146.05. This is the maximum gain of this particular trade.
• There are two break-even prices:
  • The upper break-even point is 17,846.05. This is the net premium received (146.06) plus the short call strike (17,700). As long as the Nifty doesn’t rise more than 1.53%, the trader will retain at least a portion of their gain.
  • The lower break-even point is 17,353.95. This is the short put strike (17,500) minus the net premium received (146.06). If the Nifty doesn’t fall more than 1.27%, then the trader won’t have a loss.
• The maximum loss for this strategy is -53.95. This is calculated by subtracting the lower break-even point from the long put strike (17,300-17,353.95). You can also calculate the maximum loss by subtracting the long call strike from the upper break-even point (17,846.06-17900).

What happens:

• Over the course of the next week, the Nifty stays relatively flat and closes at 17,605.85 on expiration.
• The underlying price is between the two strike prices so the trade is at the maximum profit.

Trade Results:

• Since this strategy requires multiple legs, let’s break down the profit for each leg so that you can see how the Iron Condor in this example is working.

• • Long Put (17,300)

• • • Long Put Profit = Max(0, Strike Price – Underlying Price) – Option’s Cost
    • Long Put Profit = Max(0, 17,300 – 17,605.85) – 132.85
    • This Long Put has no intrinsic value on expiration.
    • The P&L is -132.85 which is the cost to buy the option.

• • Short Put (17,500)

• • • Short Put Profit = Premium Received – Max(0, Strike Price – Underlying Price)
    • Short Put Profit = 207.60 – Max(0, 17,500 – 17,605.85)
    • This Short Put has no intrinsic value on expiration.
    • The P&L is +207.60 which is the premium initially received.

• • Short Call (17,700)

• • • Short Call Profit = Premium Received – Max(0, Underlying Price – Strike Price)
    • Short Call Profit = 193.30 – Max(0, 17,605.85 – 17,700)
    • This Short Call has no intrinsic value on expiration.
    • The P&L is +193.30 which is the premium initially received.

• • Long Call (17,900)

• • • Long Call Profit = Max(0, Underlying Price – Strike Price) – Option’s Cost
    • Long Call Profit = Max(0, 17,605.85 – 17,900) – 122.00
    • This Long Call has no intrinsic value on expiration.
    • The P&L is -122.00 which is the cost to buy the option.

• When you sum the P&Ls of the individual legs, you get to the strategy’s profit which is 146.06. This is also the maximum profit for this strategy.

Scenario 2 – Underlying closes outside one of the outer strike price

The Situation:

• Once again, the trader believes the Nifty won’t move from its current price over the next two weeks. Currently, the Nifty is trading at 16,522.75.
• The trader decides to enter into an Iron Condor Strategy. The trader decides to enter into the short strangle portion of the Iron Condor with a spread of 400 surrounding the current price. The trader also decides to purchase strikes at the +200 and -200 price points surrounding the short strangle. Specifically, the trader buys and sells the following call and put options:

• The total net premium received by the trader is 128.65. This is the maximum gain of this particular trade.
• There are two break-even prices:
  • The upper break-even point is 16,928.65. This is the net premium received plus the short call strike (16800+128.65). As long as the Nifty doesn’t rise more than 2.46%, the trader will make a profit.

• • The lower break-even point is 16,271.35. This is the short put strike minus the net premium received (16400-128.65). If the Nifty doesn’t fall more than 1.52%, then the trader won’t have a loss.
• The maximum loss for this strategy is -71.35. This is calculated by subtracting the lower break-even point from the long put strike (16,200-16,271.35). You can also calculate the maximum loss by subtracting the long call strike from the upper break-even point (16,928.65-17,000).

What happens:

• By the end of the first week, the Nifty trades relatively flat and closes at 16,478.10. At this point, your trade is profitable because the Nifty is between the two short strikes of 16,400 and 16,800. If you were to close out the position now, it would cost you 87.45 leading to a profit of 41.20 (128.65 credit to open - 87.45 to close). This is a result of:

• • The long put lowering in value from 146.70 to 61.40. You would receive 61.40 if you sold the put.
  • The long call lowering in value from 74.85 to 12.05. You would receive 12.05 if you sold the call.
  • The short put lowering in value from 217.50 to 123.75. It would cost you 123.75 to buy back the put.
  • The short call lowering in value from 132.70 to 37.15. It would cost you 37.15 to buy back the call.
• Throughout the second week, the Nifty starts to trade downward significantly. On expiration, the Nifty closes down to 15,360.60. This is a total loss of around 7.0% during the second week of the trade.

Trade Results:

• As in the scenario above, we will analyse the profit and loss of each individual leg.

• • Long Put (16,200)

• • • • Long Put Profit = Max(0, Strike Price – Underlying Price) – Option’s Cost
      • Long Put Profit = Max(0, 16200 – 15360.60) – 146.70
      • This put option we purchased has an intrinsic value of 830.40 (16,200 – 15,360.60).
      • The cost to purchase this option was 146.70 so the net profit & loss for this leg of the iron condor is 692.70.

• • Short Put (16,400)

• • • Short Put Profit = Premium Received – Max(0, Strike Price – Underlying Price)
    • Short Put Profit = 217.50 – Max(0, 16,400 – 15,360.60)
    • The put option that we sold short has intrinsic value on expiration. The value of the option is 1039.40 (16,400 – 15,360.60). However, since we sold this short, the impact to our P&L is -1039.40.
    • We received an initial premium of 217.50 for shorting the option. The net profit & loss of this leg of the iron condor is -821.90.

• • Short Call (16,800)

• • • Short Call Profit = Premium Received – Max(0, Underlying Price – Strike Price)
    • Short Call Profit = 132.70 – Max(0, 15,360.60 – 16,800)
    • This Short Call has no intrinsic value on expiration.
    • The P&L is +132.70 which is the premium initially received.

• • Long Call (17,000)

• • • Long Call Profit = Max(0, Underlying Price – Strike Price) – Option’s Cost
    • Long Call Profit = Max(0, 15,360.60 – 17,000) – 74.85
    • This Long Call has no intrinsic value on expiration. The P&L is -74.85 which is the cost to buy the option.
• The individual P&Ls of the option legs are 
  • • 692.70 (long put) 
    • – 821.90 (short put)
    • + 132.70 (short call)
    • – 74.85 (long call)
• Summing these values gets you to the strategy P&L of -71.35. If you recall from the situation section above, -71.35 is the maximum loss. As noted, the maximum loss occurs when the underlying price is at or below the long put strike or at or above the long call strike. Since the Nifty closed at 15,360.60 which is below the long put strike of 16,200, the trade resulted in the maximum loss.

• While you would lose if you held to expiration, by managing the position and exiting after the first week, this trade could have been profitable.

Scenario 3 – Underlying closes outside of one of the break-even points

The Situation:

• The trader believes the Nifty won’t move from its current price over the next few days. Currently, the Nifty is trading at 16,522.75.
• The trader decides to enter into an Iron Condor Strategy. The trader decides to enter into the short strangle portion of the Iron Condor with a spread of plus or minus approximately 50 surrounding the current price.
• The trader also decides to purchase strikes at the +200 and -200 price points surrounding the short strangle. The table below shows the call and put options that are bought and sold:

• The total net premium received by the trader is 126.50. This is the maximum gain of this particular trade.
• There are two break-even prices:
  • The upper break-even point is 17,726.50 This is the net premium received plus the short call strike (126.50+17,600). As long as the Nifty doesn’t rise more than 1.11%, the trader will make a profit. The lower break-even point is 17,373.50. This is the short put strike minus the net premium received (17,500-126.50). If the Nifty doesn’t fall more than 0.90%, then the trader won’t have a loss.
• The maximum loss for this strategy is -73.50. This is calculated by subtracting the lower break-even point from the long put strike (17,300-17,373.50). You can also calculate the maximum loss by subtracting the long call strike from the upper break-even point (17,726.50-17,800).

What happens:

• The Nifty moves up and down the first few days of the trade but on expiration date, it moves up to 17,790.35.
• While the Nifty didn’t move above the upper strike of 17,800 to reach its maximum loss, the Nifty did close above the break-even point of 17,726.50.

Trade Results:

• We can calculate the P&L of this trade by subtracting the Nifty closing value (17,790.35) from the upper break-even point (17,726.50). This results in a value of -63.85. As a reminder, the maximum loss we calculated for this example is -73.50. In this example, we lost 86.9% of the maximum loss.

• We calculated the P&L above using a short method. But, we can also calculate the P&L by summing the profits and losses of the individual legs of the iron condor.

  • Long Put (17,300)

    • • Long Put Profit = Max(0, Strike Price – Underlying Price) – Option’s Cost
      • Long Put Profit = Max(0, 17,300 – 17,790.35) – 48.60
      • This put option we purchased has no intrinsic value. The cost to purchase this option was 48.60 so this leg of the strategy resulted in a loss of -48.60.

• • Short Put (17,500)

• • • • Short Put Profit = Premium Received – Max(0, Strike Price – Underlying Price)
      • Short Put Profit = 113.00 – Max(0, 17,500 – 17,790.35)
      • The put option that we sold short has no intrinsic value. The premium that we received was 113.00 so we retain this total for a profit of +113.00.

• • Short Call (17,600)

• • • • Short Call Profit = Premium Received – Max(0, Underlying Price – Strike Price)
      • Short Call Profit = 99.50 – Max(0, 17,790.35 – 17,600)
      • This Short Call is the only option in the strategy that has intrinsic value of 190.35 on expiration. Due to the trader shorting this option, this trade ends with a loss of -190.35. To offset this loss, the trader initially collected the premium of 99.50 when they sold the option. The net loss is -90.85 

• • Long Call (17,800)

• • • Long Call Profit = Max(0, Underlying Price – Strike Price) – Option’s Cost
    • Long Call Profit = Max(0, 17,790.35 – 17,000) – 37.40
    • This Long Call has no intrinsic value on expiration. The P&L is -37.40 which is the cost to buy the option.
  • The individual P&Ls of the option legs are 
    • -48.60 (long put) 
    • +113.00 (short put) 
    • – 90.85 (short call) 
    • – 37.40 (long call)
  • Summing these values gets you to the strategy P&L of -63.85.

To Conclude:

• Use Iron condor when you believe the underlying will not be volatile before expiry.Use this strategy when you do not have a forecast for how the market will move.
• An iron condor trade is most successful if the underlying security doesn’t move.
• Iron condor is a four-leg strategy comprising a short strangle and a hedge. 
• It consists of buying a call and put as well as selling a call and put.
• The put is purchased at a strike lower than the sold put and the call is purchased at a strike higher than the sold call.
• The maximum profit occurs when the underlying closes in between the two shorted strike prices.
• An Iron Condor has two break-even points.
• The iron condor does not turn profitable at the break-even point; rather it becomes unprofitable above and below the break-even points.
• Maximum loss in an Iron Condor is capped because the purchased long call and put options act as a hedge against the potential loss of the short call and put options.

Key Formulae

• Iron Condor Profit = Short Call Profit + Short Put Profit + Long Call Profit + Long Put Profit
  • Short Call Profit = Premium Received – Max(0, Underlying Price – Strike Price)
  • Short Put Profit = Premium Received – Max(0, Strike Price – Underlying Price)
  • Long Call Profit = Max(0, Underlying Price – Strike Price) – Option’s Cost
  • Long Put Profit = Max(0, Strike Price – Underlying Price) – Option’s Cost
• Iron Condor Break-even Point #1 = Short Put Strike – Net Premium Received
• Iron Condor Break-even Point #2 = Short Call Strike + Net Premium Received

The overriding goal of an iron condor thus, is to profit from low volatility. Since it involves buying both calls and puts, this is a strategy that looks out for you - in that, it caps your loss and your profits as well. Up next, a strategy that is actually comparable to buying insurance. See you there.