What is Iron Condor?
Iron Condor is a derivative strategy that is designed to earn profit in a limited loss and a limited profit basis and therefore, it consists of four options – long call, short call, long put and a short put, all with the same expiration date, however, are of different strike prices. This helps to create a strategy aimed at earning profit in a non-volatile market.
Explanation
Iron Condor consists of 4 options:
- Long Put
- Short put
- Long Call
- Short Call
All four options are being placed at different strike rates. So there are four strike rates in the strategy. The selection of strike pricesStrike PricesExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more and the prediction of volatility plays an important part in this strategy. The strategy can help to provide sustainable income if someone believes that the Non-Volatility of the market will persist.
You receive money when you sell options and pay when you buy them. The options are bought and sold in such a manner that there is an initial inflow at the initiation of the strategy. The initial inflow is the maximum profit that a person can earn from this strategy.
The strike prices will be chosen in such a way that if the price of the share remains in between the middle two strike prices, then the strategy will provide maximum profit.
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For eg:
Source: Iron Condor (wallstreetmojo.com)
Characteristics
- This strategy is based on options, which are derivative instruments. So the security on which the strategy is planned should have its presence in the derivative marketDerivative MarketThe derivatives market is that financial market which facilitates hedgers, margin traders, arbitrageurs and speculators in trading the futures and options that track the performance of their underlying assets.read more.
- The Iron Condor is only applicable when the market is Non-Volatile. In the case of a volatile market or extreme movements, the strategy will incur a loss.
- There is an initial inflow in the strategy, which is the maximum profit from the strategy.
- The strategy will result in a maximum profit if the price of the underlying security remains between the middle strike prices.
- The Call and Put options are bought to avoid extreme outcomes that are when the stock price starts to move in one particular direction.
- If the Non-Volatile market persists, then this strategy can help to earn a sustainable profit.
How to Construct an Iron Condor?
Iron Condor is constructed using four options
- Long Put
- Shot Put
- Long Call
- Short Call
The main concept behind this strategy is that the investor thinks the price of the security will not move much. You all know that when you sell options, there is limited profit but unlimited loss potential. So if an investor thinks that the stock price will not move, then he will sell options to earn the premium. The investor will sell at the moneyAt The MoneyATM refers to a situation in which the option holder's exercise of the option results in no loss or gain since the exercise price or strike price is equal to the current spot price of the underlying security. read more or close out of the moneyOut Of The Money”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value.read more “put” and “call” and will earn a higher premium. Considering investors only sold put and Call, then it is a great risk to the investor if the stock price either moves up or down. If the stock price moves up, then there will be huge losses in the call that is sold. If the stock price moves down, then there will be lost from the Short put.
So to prevent extreme outcomes, the investor will have to hedge himself by buying options. So to hedge from Short Call, the investor will have to buy a call option and to save from short put, the investor will have to buy a put option.
OTM call and Put options will have a cheaper premium, so buying them will incur less cost now, if you club the Inflows and Outflows. Then you incurred expenses for buying options and received premiums for selling options. In net, you have received money at the beginning of the strategy.
Now, if the stock price doesn’t move, then all the options will expire, and the investor will have the initial inflow with him. This is the maximum profit. If the stock price moves, then investors will lose the initial inflow and will start incurring losses. The losses will be limited to a bracket.
Example of Iron Condor
The share price of XYZ is $100. Mr. X thinks that the price of the stock will remain at that level. So he is planning to set up a strategy to earn from the Non-Volatility. Premiums of Options are mentioned below
- Call Option @102 Strike – $10 Premium
- Call Option @115 Strike – $ 5 Premium
- Put Option @ 98 Strike – $ 12 Premium
- Put Option @ 80 Strike – $ 7 Premium
Soln:
The Call option with strike 102 is very close to the share price, so it is a kind of ATM call. By selling this option, Mr. X will earn a $ 10 premium. To safeguard from sudden movement in stock price, he will buy an OTM call option by paying a premium of $5. So-net premium earned in this leg is ($10 – $5) = $5
Mr. X is betting that the stock price will not move, so he will also bet on the downside. As he thinks that the price will not go down, so he will sell a near ATM put into earning a higher premium. The premium earned from the put @ strike 98 is $12. However, if the stock price falls below expectations, then Mr. X will incur a loss. So he will have to buy a put option in order to protect himself. The premium for OTM put is less.
- So Mr. X will buy an OTM put @ strike 80 by paying $7.
- Net inflow from this leg is ($12 – $7) = $5
- Total inflow from both the legs = $5 + $ 5 = $ 10
1st Scenario:
If the stock price remains between $98 to $102. Then all options are worthless, and the investor earns $10.
2nd Scenario:
Suppose the stock price goes below 98 and reaches 80. Then the call options are worthless. There will be lost from the Short put. The loss amount is ($98 – $80) = $18. Once the stock reaches $80, the Long put will prevent the investor from further losses.
So the inflow was $10 and Outflow $18, Net loss $8.
3rd Scenario:
Suppose the stock price moves above 102 and reaches $115. The put options will expire worthlessly. Then the loss from the short call will be ($115 – $102) = $13. When the stock price reaches $115, the long call will protect from further losses.
So the Total Inflow was $10 and outflowed $ 13. So-net loss is $3.
Hence it is proved that this strategy is profitable only when the stock price remains in the middle.
Advantages
- It helps to earn a sustainable income when the market is Non-Volatile.
- This is a limited risk and limited profit strategy. So the investor will not have a fear of having unlimited risk due to option selling.
- There is an initial inflow of money that can be used to earn interest.
Disadvantage
- The strategy ends up in loss when the prices move abruptly.
- This strategy will only be applicable for securities trading in the derivatives market.
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