The iron condor is a trading strategy for options that uses two spreads, both vertical. One is a call (which is the option to buy), and the other is a put (the option to sell). The iron condor gets its name from the shape of the profit and loss graph it creates.
An iron condor appears vertically, composed, again, of four trades – calls and puts – all with the same expiration date. It is why the graph representation is vertical. The shape that the profit/loss graph makes simulates something like a large bird, which is how the iron condor was named. (A condor is, of course, a large, predatory bird).
An iron condor uses two spreads (a call spread with two positions and a put spread with two positions); the goal with a long condor is to keep the trading range (of the option’s underlying security) pretty narrow; the goal with a short condor strategy is high volatility sufficient to put one of the short options in the money.
The iron condor is formed from the short (inner) positions – which form the body and the long (outer) positions which form the wings; the iron portion of the name comes from the fact that both call and put options are used.
Maximum profit with a long condor is acquired if all options expire with positions remaining out-of-the-money; maximum short condor profit is achieved when either the short put or short call option is in the money.
Long and Short Condors
There are two positions a trader may take when using the iron condor strategy. In both cases, the strategy uses a balanced buying and selling of the calls and puts involved. A trader basically covers both sides of the option’s underlying asset with long and short puts and calls. He covers every position by buying and selling the same number of out of the money calls and puts, each respective to one another.
Long Condor Strategy
The long condor strategy is used when a trader expects low volatility in the underlying asset.
On the call option side, the trader employs a bear call spread – selling short a call with a lower strike price and buying a call with a higher strike price. On the put option side, the trader uses a bull put spread – buying a put with a lower strike price and selling a put with a higher strike price. The call option strike prices are both out of the money above the price of the underlying security, while the put option strike prices are both out of the money below the price of the underlying security.
Short Condor Strategy
The short condor strategy is used when a trader expects high volatility in the underlying asset.
A short condor is the opposite of the long condor. The trader uses a bull call spread and a bear put spread – selling a call option with a higher strike price and buying a call option with a lower strike price – and selling a put with a lower strike price while buying a put option with a higher strike price. Again, as with the long condor, the call option strike prices are out of the money above the price of the underlying security, while the put options are out of the money below the price of the underlying security.
Regardless of whether the condor strategy is long or short, all options should have the same expiration date.
The Formation of the Condor
As mentioned above, an iron condor gets its name due to the shape that the profit/loss graph creates. To maintain the analogy to a large, predatory bird, traders collectively relate the inner options as the body of the bird. The outer options, then, are known as the wings. The image below offers a basic representation of what an iron condor would look like:
So, the collection of inner and outer positions forms the condor shape. The word “iron” comes into play because the strategy uses both calls and puts. A simple condor position would be comprised of all calls or all puts.
Profit and Loss with the Iron Condor
A trader is shooting for a narrow trading range (fluctuation of price) with a long iron condor. In a perfect scenario, if all options are out-of-the-money (OTM) when the date of expiration arrives, the options close worthless, and the trader is able to keep what remains from the net of premiums received when putting on the four option positions, after deducting all commissions. Such a situation won’t happen with each trade; most iron condors end with at least one of the options being at-the-money or in-the-money.
The maximum potential loss with a long iron condor occurs when, at expiration, the price of the underlying security is above the strike price of the long call option or below the strike price of the long put option.
Frequently, it’s better for a trader to close a position early and lose out on some of the potential for profit. It is specifically true when the underlying security is volatile, and the trading window fluctuates significantly. Risk management is key in such a strategy; therefore, it is best used by experienced traders.
Maximum profit using the short iron condor strategy is obtained when the price of the underlying security drops below the strike price of the short put option or is higher than the strike price of the short call option. The maximum potential loss is simply the debit incurred when putting on the four option positions.