Construction
A reverse iron condor is the combination of a put bear spread and a call bull spread. It is the opposite of the iron condor strategy and it involves four strikes which are all OTM. Specifically it consists of a short OTM put and a long OTM put with higher strike, plus a short OTM call and a long OTM call with lower strike. All options have the same expiration date.
It is an alternative of the reverse condor strategy. Their differences is that the reverse condor is consisted only of calls or only of puts and it is a credit spread with two ITM options, whereas the reverse 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 reverse iron condor is a debit spread because the money we earn from the short options is less 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 a reverse iron condor when the stock price is at $25.
When to use
Like the short butterfly with calls or puts and the long strangle, when we believe that the price of the underline security will move sharply in either direction, at least beyond the furthermost strikes.
In order to achieve the maximum possible profit we want the price of the underline security at expiration to be anywhere beyond the strikes of the short put and the short call ($21 and $29 in the above example). Anywhere within the long and the short call strikes ($27 and $29) or the short and the long put strikes ($21 and $23), we can have either a loss or a profit depending on the premium paid 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 within the long put and the long call strikes ($23 and $27). The longer this distance is, the more difficult it is for the price to be beyond that range but the maximum profit will be bigger than in the case in which this distance is shorter. This happens because options that are near ATM have higher premiums than those which are OTM with the same characteristics. So, the net debit we have to pay if the long options are near ATM is higher, hence the profit is lower.
Loss/Profit at expiration
Maximum loss: Net premium paid + commissions.
Maximum profit: Difference between calls strikes or puts strikes – net premium paid – commissions.
Profit/Loss diagram
Below we can see the profit/loss diagram for the reverse 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.
Reverse iron condor strategy example
In the daily chart of stock C (below) we believe that due to high market volatility, the price will break the support (line 1) or the resistance (line 2) in about a month. The stock is already consolidating for a long period of time and its price has visited the support and resistance lines for more than once, which augments the possibility of a breakout or breakdown. When the stock is at point A ($27.20) we can buy five calls with strike $28 and premium $0.60 and write five calls with strike $29 and premium $0.30. Simultaneously we can write five puts with strike $25 and premium $0.20 and buy five with strike $26 and premium $0.50. The expiration of all options will be about after one month. The net premium paid 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 reverse 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 long options ($26-$28), then all options are expiring worthless and we take the maximum loss which is equal to the net premium paid ($300), plus commissions.
If the price of the underline at expiration is let’s say above the higher strike i.e. at $32, then the puts are expiring worthless, the long calls with the lower strike ($28) produce a profit of $2000 [($32-$28)x500] and the short calls with strike $29 are exercised against us producing a loss of $1500 [($32-$29)x500]. So, the profit from the options is $500 ($2000-$1500). If we subtract the net premium paid for the opening of the position ($300), then we have a final net profit 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.