What is an Iron Condor in Option Trading?

5 mins read

Options contracts were first introduced to hedge the current holdings against sudden market crashes or to protect them even in case of a severe correction. Later the traders and investors on Dalal Street made use of these derivatives contracts in different ways to not only hedge their positions but also to initiate trades and make some income out of them.

Iron Condor is one of the many strategies that the F&O traders use to trade in stock and index options. It involves buying and selling of call and put options to lock in the gain or loss. To be able to trade with this strategy, one must have a deep understanding of what is iron condor in options trading. So, let’s begin!

What is Iron Condor?

The iron condor is a strategy that consists of four options contracts of the same expiry. It is designed to gain from the low volatility of an asset. The iron condor is similar to other spreads, but instead of either the call or put, it uses both of them.

The Iron Condor is one of the stock options spread trades that consists of two separate spread trades. It works by assuming that a stock will not trade above or below a set number of days in a row. The trader retains his or her full gain if the stock reaches that level.

Process of Iron Condor Strategy

The process of entering the iron condor strategy in options trading involves taking four trades. It required selling and buying of call and put options, both. Below-mentioned is the procedure in which you can enter into a position using the iron condor trading strategy.

  1. Buying an out of money put option
  2. Selling an at or out of money put option
  3. Buying an out of money call option
  4. Selling an at or out of money call option

The two options that are bought are far out of the money and have lower premiums than the two written options. Since they are long positions, they have a net credit to the account.

How does Iron Condor work?

The iron condor strategy has a limited risk of upside or downside due to its higher and lower strike prices. Its potential to bag the gains is restricted due to its limited leverage.

Ideally, the trader might want all the options contracts to end up value-less. This strategy works if the stock price does not close between the two prices of options that a trader sold, at expiration.

By choosing the right strike prices, it is also possible to make a strategy lean towards either a bullish or bearish stance.

Advantages of Iron Condor

To understand what is iron condor in options trading, let us glance at its advantages.

Higher Premium Collection

The biggest advantage of having multiple spread positions is that you can collect twice as much premium.

Fixed Gain on Half of the Trade

Since the price of stock or index value can’t close both below the put and call strike prices at the same time, one of those legs will expire worthlessly.

Flexibility

The concept of iron condor is that it’s flexible when it comes to buying or selling an option. The long option can be bought back if the stock price moves up or down. It provides flexibility to traders.

Disadvantages of Iron Condor

Some of the cons of the iron condor strategy are listed below.

Bigger Potential Loss

While it is an advantageous method when it comes to having a high potential return on the invested capital, it can also be very risky.

Risk of Over-leveraging

The required capital to establish an iron condor is less, it’s easy to set up multiple iron condors. With an advantage on margin requirement, a trader could build positions that might be difficult to handle.

Understanding what are Iron Condors with Example

Let us understand what is iron condor by taking a hypothetical situation. Suppose you analyzed that the stock X, which is priced at Rs. 200 at present, will remain range-bound for another month. In this case, you can build an iron condor strategy based on analysis as follows:

  • You sell the 210 call option for Rs. 20 and buy the 220 call option for Rs. 7. In this case, you collected Rs. 14 premium on a net basis.
  • Next, you sell the 190 put option for Rs. 18 and buy the 180 put option for Rs. 6. Here, you collected a net premium of Rs. 12.

The total credit of premium in your account will be Rs. 26. If the lot size is 100 shares, you collected Rs.2,600 on this whole setup. This means that if the stock price of X ends between Rs. 210 and Rs. 190, you will earn this whole amount as your gain.

The loss will increase if the share price goes near Rs. 180 or Rs. 220. And if the stock price of X goes beyond that, then the losses will be the highest.

In Nutshell

The iron condor strategy is best suited to seasoned traders who have been in the market for a long time. It works best if you are expecting low volatility and want to maximize your profits. The key to this strategy is to find the two inner strike prices that are between the two major strike prices. This is the sweet spot for this strategy. Although iron condors can produce high returns, they are not without risk.