How Does an Iron Condor Strategy Work? - SmartAsset

The iron condor is a strategy in options trading. As with all options strategies, it is based on assembling a position out of several contracts. In this case, the iron condor is built out of four contracts: two short positions and two long positions. You profit by selling the short contracts and cap your risks with the long ones. You would take this position when you expect a low-volatility market. If prices don’t change very much, you will profit. If they change considerably, you can lose money.

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What Is an Iron Condor?

An iron condor is named after the shape this trading strategy makes on a profit/loss diagram. It is built out of four simultaneous positions: A put and a call contract that you buy, and a put and call contract that you sell.

Put/Call: A put option is one in which the holder has the right to sell the underlying asset for a certain price on a specific date. A call option is one in which the holder has the right to buy the underlying asset for a certain price on a specific date.
Long/Short: A long position in an options contract means that you bought the contract and hold the rights that this contract gives. A long-call means you can sell the asset, a long-put means that you can buy it. A short position means that you sold the contract and must honor the rights of whoever holds it. A short-call means that you have to buy the asset from whoever holds the contract should they exercise their option, a short-put means that you must sell the asset.

To build an iron condor position, you would enter four options contracts with different strike prices and the same expiration date:

Long-Call: Buy a call contract with a strike price above the current price of the asset.
Long-Put: Buy a put contract with a strike price below the current price of the asset.
Short-Call: Sell a call contract with a strike price above the current price of the asset but below the strike price of your long call.
Short-Put: Sell a put contract with a strike price below the current price of the asset but above the strike price of your long put.

In a classic iron condor your long positions are equally distant from the asset’s current price, forming the “wings” of the condor. (For example if your long call has a strike price $10 above the asset’s current price, your long put will have a strike price $10 below.) The short positions are closer to the asset’s price than your long positions, and also mirror each other. While standard it is not essential that your positions mirror each other, and variations on the iron condor can change this relationship.

Once you have built the iron condor you will hold four mutually offsetting contracts with the current price of the asset sitting in between.

Example of an Iron Condor

Let’s say you want to open an iron condor position on XYZ Corp. Its stock is currently selling for $20 per share. You might enter the following contracts:

Long-Call for $30, Expiration on July 1
Long-Put for $10, Expiration on July 1
Short-Call for $25, Expiration on July 1
Short-Put for $15, Expiration on July 1

You would now hold offsetting long positions, which guarantee you the right to buy the asset for $30 and also to sell it for $10 if you choose. These are the wings of your condor spread.

You also hold offsetting short positions, which require you to sell the asset $25 and also to sell it for $15 if the contract holders exercise their options.

How Does an Iron Condor Work?

The key to an iron condor is the premiums that you collect and pay on these contracts.

The premiums on an options contract are priced based on how close it is to being in the money. The closer the contract is to being in the money, the higher its premium. (Essentially it costs more to buy an option that’s more likely to expire profitably.)

In an iron condor your long positions have strike prices further from the securities’ current price than your short positions do. This makes your long positions less expensive because they’re less likely to close profitably.

This relationship is the key to an iron condor. When you open this position you sell a series of contracts and collect the premiums. Then you buy a series of contracts that are further out of the money and, therefore, cheaper than the short positions you just sold.

This puts you in a position of net income (or profit). You collect more by selling your short positions than you spend to open your long positions.

For example, in our case above your premiums might look like this:

Long-Call for $30, Expiration on July 1, Premium $1
Long-Put for $10, Expiration on July 1, Premium $1
Short-Call for $25, Expiration on July 1, Premium $2
Short-Put for $15, Expiration on July 1, Premium $2

Since the asset price is $20, the short positions are closer to being in the money which makes them more expensive.

Options sell in 100 contract bundles. This means that your total spending is:

Long Positions: 200 contracts at $1 per contract = $200 spent
Short Positions: 200 contracts at $2 per contract = $400 collected

When you open this iron condor on XYZ Corp. you start with a $200 profit.

Iron Condors Profit From Stability

Overall, an iron condor is a very stable position. Your profits and your losses are fairly low but they’re also capped. Your maximum profit on an iron condor is the premiums you collect selling short positions. So long as the asset’s price doesn’t change enough to pass the strike price of either short position that you’ve sold, no one will exercise their contracts. Every position will expire out of the money and you will keep your premiums.

Your maximum loss on an iron condor occurs if the asset’s price exceeds the strike price of either your long call or your short call.

Once the asset price moves past either of the short position strike prices you will have to honor one of those contracts. If it increases too far, you will have to honor the short call position you took and sell this asset for less than it’s worth. If the asset’s price decreases too far, you will have to honor your short put position and buy the asset for more than it’s worth. In either case you lose money if these losses exceed the premiums you collected selling those short positions.

However, your losses are capped by your own long positions. Once the asset reaches your long position strike price you make money off that contract. The money you make off your long position will offset any additional money you lose off your short position. As a result, your losses are capped based on where you set your long position strike prices.

Ultimately, the maximum loss for any iron condor is defined as the difference between your short and long put positions or your short and long call positions (whichever is greater), times the number of contracts you sold, reduced by the premiums you collected.

When you establish an iron condor, where you build your long and short strike prices is a key factor of risk management. The further out you set your long strike prices, the less money you will pay in premiums. This will increase your potential profits but will also increase your potential losses. The inverse is true of short strike prices. The closer you set short strike prices to the asset price the more you can collect in premiums, but the more likely it is that you will end up paying that contract out.

Iron Condor Profit/Loss Example

Let’s look at our position on shares of XYZ Corp. again. This asset currently sells for $20, and as a reminder we have entered the following iron condor on it:

Long-Call for $30, Expiration on July 1, Premium $1
Long-Put for $10, Expiration on July 1, Premium $1
Short-Call for $25, Expiration on July 1, Premium $2
Short-Put for $15, Expiration on July 1, Premium $2
Total initial position: $200 profit from premiums

We start $200 up based on the difference between the premiums we paid for our long positions and the premiums we collected on our shorts. If XYZ Corp. stays between $25 and $15, all of these contracts will expire out of the money. No one collects on anything and our net profit is $200.

We have built this position around that hope of stability. However, we also have a risk of loss. Based on our formula above, that maximum risk is as follows (note that x below means multiply):

$5 (the maximum difference between our short and long strike prices) x 100 (the number of contracts we sold) – $200 (the premiums we collected)
($5 x 100) – 200 = $300
We can lose up to $300 on this position

For example, let’s say that the price of XYZ Corp. increases to $28 on the expiration date. In that case here’s how our contracts would close:

Long-Call for $30, Expires out of the money
Long-Put for $10, Expires out of the money
Short-Call for $25, Expires in the money at $3 per contract
Short-Put for $15, Expires out of the money

The short call we sold expires in the money. We have to buy 100 shares of XYZ Corp. at $28 per share then sell it to the contract holder for $25 per share, for a loss of $3 per contract. With 100 contracts we will lose $300, which puts our final position at a $100 loss.

Now let’s say, on the other hand, that the price drops all the way to $5 per share. In that case:

Long-Call for $30, Expires out of the money
Long-Put for $10, Expires in the money at $5 per contract
Short-Call for $25, Expires out of the money
Short-Put for $15, Expires in the money at $10 per contract

The put that we sold expires in the money, and we lose $10 per contract on it for a loss of $1,000 (we sold 100 contracts and lost $10 apiece). However, the put that we bought also expires in the money, and we make $5 per contract for a total gain of $500.

Our long put offsets our short put, capping our losses at $500, which leads to our maximal loss of $300 on this position. Note that you don’t automatically lose money if the asset, in this case stocks, exceeds its short position strike price. For example, if XYZ Corp. were to drop to $14, you would lose $1 per contract that you sold. This would still leave you with a $100 profit.

Bullish/Bearish Iron Condors

Finally, while beyond the scope of this article, it’s important to note that you can establish variations on iron condors by shifting how you balance your strike prices. A classic iron condor is symmetrical. Your long and short positions (the wings of the condor) are each equally distant from the asset’s current price (the body of the condor). Your call and put positions are both above and below the current asset price, respectively.

However, this is not necessary. By adjusting how you balance these four strike prices you can create variations on the iron condor. For example, if you sell your short positions both below the asset’s current price you can create a bearish iron condor that bets on prices falling before they stabilize. There are many versions on this trading strategy, but they all are built around the basic structure of capped losses and risk management.

Bottom Line

An iron condor is an options trading strategy in which you open up four mutually offsetting contracts in the expectation that the security’s price will not change much, if at all. Your goal is to profit off the premiums on a series of short contracts that you sell, while mitigating your risks with a series of long positions.

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