Construction
An iron condor is the combination of a put bull spread and a call bear spread. It involves four strikes which are all OTM and it consists of a long OTM put and a short OTM put with higher strike, plus a long OTM call and a short OTM call with lower strike. All options have the same expiration date.
It is an alternative of the condor strategy. Their differences is that the simple condor is consisted only of calls or only of puts and it is a debit spread with two ITM options, whereas the iron condor is consisted of calls and puts which are all out of the money (OTM). Also, the profit/loss diagram and the purpose of the strategies remain the same, but the maximum loss and profit are reverse.
The iron condor is a credit spread because the money we earn from the short options is more than the money we have to pay for the long options.
For better representation of this complex spread we can see the table below, which describes the legs of an iron condor when the stock price is at $25.
When to use
Like the long butterfly with calls or puts and the short strangle, when we believe that the price of the underline security will not move much in either direction or it will remain confined within a price range for the time horizon of the trade.
In order to achieve the maximum possible profit we want the price of the underline security at expiration to be anywhere within the strikes of the short put and the short call ($23 and $27 in the above example). The longer this distance is, the more possible it is for the price to be within that range but the maximum profit will not be as big as if the distance were shorter. This happens because options that are near ATM have higher premiums than those which are OTM with the same characteristics. Anywhere within the short and the long call strikes ($27 and $29) or the short and the long put strikes ($23 and $21), we can have either a loss or a profit depending on the premium received for the opening of the position and the distance of the strikes.
Maximum loss occurs when the price of the underline security at expiration is at or above the higher strike price ($29 in the above example) or at or below the lower strike ($21 in the above example).
Loss/Profit at expiration
Maximum loss: Difference between calls strikes or puts strikes – net premium received + commissions.
Maximum profit: Net premium received – commissions.
Profit/Loss diagram
Below we can see the profit/loss diagram for the iron condor strategy. The table describes the options strikes and their premiums on which the particular diagram is based, assuming that the stock at the opening of the position costs $24.
Iron condor strategy example
In the daily chart of FCX below, we expect that the price will be consolidating for about a month between a support (line 1) and a resistance (line 2). We believe that the stock will end up somewhere between $32 and $34. When the price is at point A (almost $33) we can buy five calls with strike $35 and premium $0.30 and write five calls with strike $34 and premium $0.60. Simultaneously we can write five puts with strike $32 and premium $0.50 and buy five with strike $31 and premium $0.20. The expiration of all options will be about after one month. The net premium received for opening the position is $300 {[($0.50+$0.60)-($0.30+$0.20)]x500}. We have just apply the strategy by opening a position involving five iron condors (for better representation of the strategy and its legs see table below).
If the price of the underline security at expiration is between the strikes of the short options ($32-$34), then all options are expiring worthless and we achieve the maximum profit which is equal to the net premium received ($300), minus commissions.
If the price of the underline at expiration is let’s say above the higher strike i.e. at $37, then the puts are expiring worthless, the long calls with the higher strike ($35) produce a profit of $1000 [($37-$35)x500] and the short calls with strike $34 are exercised against us producing a loss of $1500 [($37-$34)x500]. So, the loss from the options is $500 ($1500-$1000). If we subtract the net premium received from the opening of the position ($300), then we have a final net loss of $200 which is the maximum possible.
Notice that we can close the whole position or any leg suits us at any time before expiration.