An iron condor is an option strategy that may sound complicated, but it really is not.
It is as simple as combining two credit spreads. It is not complicated but managing the position may be. A call credit spread is implemented above the current stock price and a put credit spread is implemented below. The objective of any credit spread is to profit from the short options’ time decay while protecting the position with further out-of-the-money long options.
Many option traders who trade iron condors will base the credit spreads off potential support and resistance levels. Some may use a certain delta and others may choose another form of technical analysis to base the spreads off. The trade is based on the possibility of the stock trading between both credit spreads by expiration. Let’s take a look at a recent example.
When Netflix Inc. (NASDAQ:NFLX) was trading around $488, the stock had some potential resistance at about $500 and some potential support near $475, as seen on the 15-minute chart below.
A call credit spread with the short strike call at 500 or higher would expire worthless if the stock stayed below $500 at expiration. A short strike put at 475 or lower would expire worthless if the stock stayed at $475 or higher at expiration. Both short options would need to be protected by further out-of-the-money long options. Both spreads would expire worthless and both premiums are the traders to keep if NFLX closes at or between the short strikes. The total risk on the trade is also reduced because of both premiums received.
In this particular example, the 500/505 call spread was sold and the 470/475 put spread was sold for a total credit of 1.10 ((7.85 – 6.80) + (6.95 – 5.90)) as seen below. The $1.10 (or $110 in real terms) is the max profit potential. Max risk is the difference between the strikes minus the total credit. In this case, max risk is 3.90 (5 – 1.10).
Max profit is achieved if all the options expire worthless at expiration (at or between $475 and $500). Maximum loss would occur if the stock is at or below $470 or at or above $505 at expiration. No matter what happens, one of the credit spreads will always expire worthless. This of course does not guarantee a profit though.
Iron condors are a great way to take advantage of time decay (positive theta) when it looks like the stock will be trading in a range for a certain amount of time. The key is to have your profit and loss parameters set before entering, which is critical for any trade.