There are many different options trading strategies for traders today. Of these, some possess a higher risk than others. And there are some strategies that limit the risk involved in a trade. The iron condor is one such limited-risk strategy. It’s a trading technique that helps you take advantage of low-volatility market conditions.
Let’s get to know the iron condor option strategy better.
What is the iron condor?
The iron condor option strategy involves the use of call and put options. All in all, it revolves around four options, each with the same date of expiration.
To construct an iron condor, here’s what you need to do.
– Sell an out-of-the-money put
– Sell an out-of-the-money call
– Buy a further out-of-the-money put
– Buy a further out-of-the-money call
As you can see, the iron condor strategy involves the use of four legs of trading. This four-part strategy includes a bear put spread and a bull call spread. Here, the strike price of the long put is lower than the strike price of the long call.
Let’s take up an example to understand this trade better.
The iron condor option strategy: An example
Say a company is trading at Rs. 50 in February. Here’s what you sell or buy to execute the iron condor strategy. All the options have a lot size of 100 shares.
– You buy one March put option with a strike price of Rs. 40 (at a cost of Rs. 50)
– You buy one March call option with a strike price of Rs. 60 (at a cost of Rs. 50)
– You sell one March put option with a strike price of Rs. 45 (for a price of Rs. 100)
– You sell one March call option with a strike price of Rs. 55 (for a price of Rs. 100)
So, at the outset, your overall gain is Rs. 100 (since you received Rs. 200 for the options sold and paid Rs. 100 for the options bought).
Now, at expiry, if the price of the underlying stock closed anywhere between Rs. 45 and Rs. 55, here’s what will happen. Say the stock price on expiry is Rs. 52.
Option 1 would expire worthless, since it gives you the right to sell at Rs. 40 (instead of Rs. 52)
Option 2 would expire worthless, since it gives you the right to buy at Rs. 60 (instead of Rs. 52)
Option 3 would expire worthless, since it gives the buyer the right to sell at Rs. 45 (instead of Rs. 52)
Option 4 would expire worthless, since it gives the buyer the right to buy at Rs. 55 (instead of Rs. 52)
So, all in all, you will be left with the initial gain of Rs. 100 if you follow the iron condor strategy in this scenario.
On the other hand, if the stock closes below Rs. 45 or above Rs. 55, you will incur a loss. For instance, say the stock closes at Rs. 40 on expiry. In that case, here are the outcomes.
Option 1 would expire worthless, since it gives you the right to sell at Rs. 40 (which is the same as the market price)
Option 2 would expire worthless, since it gives you the right to buy at Rs. 60 (instead of Rs. 40)
Option 3 would not expire worthless, since it gives the buyer the right to sell at Rs. 45 (instead of Rs. 40)
Option 4 would expire worthless, since it gives the buyer the right to buy at Rs. 55 (instead of Rs. 40)
So, with regard to option 3, you will incur a loss of Rs. 5 per share (i.e. Rs. 45 minus Rs. 40). This becomes a total loss of Rs. 500. Netting it off with the initial gain of Rs. 100, you end up with a net loss of Rs. 400.
Conclusion
The iron condor option strategy is best suited for experienced traders who have been in the game for quite a while. Also, the iron condor strategy works best if you’re expecting low volatility, since ideally, you want all four of your options to expire worthless. That way, you can make a profit on the trade. The sweet spot for this strategy is between the two inner strike prices. If you’re a beginner looking to execute the iron condor strategy, it’s best to get your basics right, since it involves four legs of trade. You also need to make informed trading decisions here, because it’s important to execute this strategy only when the market conditions are just right.
