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Whether you are a new or experienced options trader, there are several strategies for you to utilize.
How can you know which one is best for you?
There is one low-risk strategy that when used correctly can generate consistent returns and doesn’t require an unreasonable amount of time to manage.
We’re talking about the iron condor strategy.
In this article, we’ll break down the iron condor strategy, along with its advantages and disadvantages, to help you decide if it's the next best strategy for you to implement.
Editor’s Note: This article includes options trading terminology and strategies. If you’re new to options trading, or have spent time away from it, we recommend brushing up on options trading fundamentals with this guide.
What is Iron Condor Options Strategy?
An iron condor is an options trading strategy consisting of selling an out-of-the-money call spread and an out-of-the-money put spread, all with the same expiration date and width between strike prices.
The strategy got its name because the graph reflecting the various profit and loss points looks like a large bird, like a condor.
This strategy is a multi-leg neutral trading strategy in which the risk is predefined, and the profit potential is limited within a single trade but consistent over multiple trades.
For a better overall understanding, let’s take a deeper look at the details of an iron condor.
Iron condors are great for monthly options with 30 - 40 days to expiration.
A conservative target should be a profit of $0.50 - $0.75 per contract.
Large market cap stocks are perfect to use because the price is less likely to be manipulated.
Stocks with an earnings call within the next 30 - 40 days should be avoided due to the potential of volatility increasing during the trading period.
Furthermore, entering an iron condor when the volatility index (VIX) is high — for example, above 23.5 — has historically provided both higher and more consistent profits.
The initial setup of an iron condor is simple. It is created by selling a call credit spread and a put credit spread, both with the same expiration date and both out-of-the-money.
The break-even point for an iron condor is relatively easy to calculate.
If you received a $5.00 credit when opening an iron condor, the break-even point would be $5.00 below the short put strike and $5.00 above the short call strike.
Making Changes to the Strategy
Changing an iron condor strategy is not uncommon. Initial changes can be made when creating an iron condor to maximize the chances of being profitable, like increasing the distance between the short strike prices.
However, this will also lower the overall amount of profit.
Changes can also be made during an iron condor if the market moves in a way that aggressively threatens your profits. Common changes include but are not limited to:
- Adding more contracts to the non-threatened side of the iron condor
- Rolling some of the contracts on the threatened side to a future date
- Purchasing additional option spreads to protect profits or minimize losses
Iron condors primarily depend on three things:
- decreasing volatility
- minimal movement in the price of the underlying stock
- time decay
If the stock price stays between the short options, the contracts will be worthless at expiration, and the credit received will be kept for maximum profit.
However, before expiration, the contracts within an iron condor can be closed to protect gains or minimize losses.
Advantages of Iron Condor Options Strategy
Why is this a popular trading strategy for conservative option traders?
The primary benefits include:
- The ability to profit if the market moves up or down
- Consistent returns due to the higher probability of success
- The risk of financial loss is limited
- Iron condors do not require a significant amount of capital
Disadvantages of Iron Condor Options Strategy
While there are minimal disadvantages to using the iron condor, it is essential to be aware of them in order to set realistic expectations and use them successfully.
The main disadvantages of using an iron condor include:
- The potential for profit is limited
- It can only be used during periods when a decrease in the volatility of the underlying stock is expected
Iron Condor Example
Let’s look at a simple example of the iron condor in action.
We will assume the trade was entered into on ABC stock, currently trading at $45 in January. Under the following circumstances, the iron condor consists of:
- Buying a FEB 35 put option for $50
- Selling a FEB 40 put option for $100
- Buying a FEB 55 call option for $50
- Selling a FEB 50 call option for $100
Using this trade setup as an example, the net credit is $100; therefore, the maximum profit is $100.
In February, if the options expire and ABC stock is trading at $35.
All of the options expire worthless except the FEB 40 put option, which for this example, has an intrinsic value of $500.
This is the price that needs to be paid to cover this expired option.
Factoring in the initial $100 credit received, the total loss is $400.
Had the option expired with ABC stock trading at $55, the loss would be the same with all options expiring worthless except the FEB 50 call option, which in this example has an intrinsic value of $500.
Even if the stock options expired higher than $55 or lower than $35, the maximum loss would still be the same. This is because the credits received versus the amount that would need to be paid for the in-the-money options would still equal $400 after factoring in the initial $100 credit received when the iron condor was first entered into.
At expiration, if the stock price falls anywhere between $35 and $55, the trade would end with varying amounts of profit — not including commissions.
However, if the options expire and ABC stock is still trading between $40 - $50, all of the options contracts would expire worthless.
Hence, in this iron condor example, you would keep the initial credit of $100 as profit.
Iron Condor Vs. Iron Butterfly
Another options trading strategy is the iron butterfly. The iron condor and iron butterfly trading strategies are similar in that they are both trading strategies that are:
- vega negative
- gamma negative
- used when implied volatility is expected to decrease
However, there are some core differences between the two methods.
Unlike the iron condor, an iron butterfly includes buying four different options contracts at three different strike prices.
In other words, an iron butterfly means purchasing an at-the-money straddle, and a further out-of-the-money strangle.
For less risk-averse traders, an iron butterfly may be a more attractive trading strategy.
Here are a few more differences:
- Iron condor is a conservative trading strategy; an iron butterfly is a more aggressive strategy
- Iron condor has lower potential profits; an iron butterfly has higher potential profits
- Iron condor has smaller, more frequent profits; an iron butterfly has larger, less frequent profits
- Iron condor has higher probability for success; iron butterfly has a lower probability for success
- Iron condor has a wider overall profit range; iron butterfly has a smaller overall profit range
- Iron condor has a wider maximum profit range; Iron butterfly has a smaller maximum profit range
An important aspect to consider is that it would be best to have a larger account balance when trading an iron butterfly as opposed to the iron condor. It will be necessary in order to withstand the increased losses that will happen when using an iron butterfly strategy.
The Bottom Line: Is the Iron Condor Right For You?
The iron condor strategy is an excellent idea for traders who do not want to spend a lot of time following the market every day.
The high winning percentage helps reduce the anxiety that can come with some trading strategies making it great for conservative traders.
No one should expect to get rich quick trading iron condors. However, if you are looking for modest but consistent profits, the iron condor may be the perfect trading strategy for you year after year.
As you can see, options trading using the iron condor trading strategy can limit financial risks while generating consistent profits.
Iron condors provide options traders the flexibility to either maximize profits or prioritize their winning percentage.
It’s not a trading method for everyone, but the results can be gratifying for those who have the time, money, and patience to execute it properly.
Practice trading them extensively with options trading simulators before trading with real money.
With time, an iron condor can be a valuable tool in your options trading toolbelt.