What are iron condors in options trading?

The mechanics of an iron condor

An iron condor functions similarly to a strangle. A short strangle is a neutral strategy that profits when the stock price remains between the short strike prices as time passes, and also benefits from decreases in implied volatility.

Key points about iron condors:

• They involve selling both a bullish spread (short put spread) and a bearish spread (short call spread) at the same time

• The position profits if the stock price settles between the strike prices at expiration

• As a spread strategy, both risk and reward are defined when entering the trade

• The maximum potential profit is the credit received upfront for selling the position

• The maximum loss is the width of the larger spread (if spread widths differ), minus the credit received

• By collecting a credit upfront and aiming for options to expire worthless, you’re essentially betting against significant movement in the underlying asset by the options' expiration date

An iron condor uses four options at different strike prices, creating a defined-risk strangle:

1. Sell 1 OTM put with a strike price nearer to the current price

2. Buy 1 OTM put with a strike price below the short put strike

3. Sell 1 OTM call with a strike price above the current price

4. Buy 1 OTM call with a strike price above the short call strike

Iron condor profit and loss explained

Iron condors are defined-risk trades with capped maximum loss and profit potential. The maximum profit is limited to the credit received upfront, while the maximum loss is confined to the width of the widest spread being in the money (ITM) at expiration, minus the credit received. This is because the long options protect against the risk in the short options if the spread moves ITM.

Iron condor maximum profit

The maximum profit potential for an iron condor is the net credit received when establishing the four-leg options position. This maximum profit is achieved when the underlying asset settles between the short strikes of the trade at expiration, causing all the options to expire worthless.

However, you don’t have to hold the strategy until expiration. If you see a 50% profit, for example, where the spread is trading for half of the credit received upfront, you can close the trade simply by placing the opposite order or buying back the iron condor using the same strikes and expiration cycle.

Iron condor maximum loss

The maximum loss is capped at the width of the widest spread, less the credit received upfront. This is equivalent to the buying power reduction (BPR) of the strategy when opening the position (excluding SPAN margin on futures products). Losses occur when the stock price moves beyond the breakeven point of the ITM short option. If both spreads are $5 wide, the maximum loss is $5 less the credit received upfront, as only one spread can be ITM at any given time.

Calculating breakeven points

When selling options, the credit received on trade entry can improve your breakeven points. Even if the short option moves ITM and acquires intrinsic value, this can be offset by the extrinsic value premium collected upfront when entering the trade and assuming the associated risk.

To calculate your breakeven points with short options, use the following formulas:

Iron condor example

To better grasp the setup and performance of iron condors in various scenarios, let's examine a practical example.

Suppose the current stock price is $500, with 60 days remaining until expiration. Both the put and call spreads have a width of $50.

To establish the iron condor position, you’d:

• Sell the 550 call option, making $8

• Buy the 600 call option for $2

• Sell the 450 put option, making $9

• Buy the 400 put option for $3

The total premium collected from selling the 450 put and 550 call is $17. The total premium paid for buying the 600 call and 400 put is $5. This equals a net premium collected of $12 ($17 - $5). In this scenario, you'd have collected more premium from the short options than what you'd paid for the long options, leaving you with a $12 net credit.

Maximum profit occurs if all the options expire worthless, with the iron condor's value at $0.00 at expiration. This happens if all the options expire OTM. The maximum profit potential is realised at any price between $450 and $550, which is ±10% from the stock entry price. The maximum potential profit is $1,200, calculated as the $12 net credit collected for selling the iron condor x 100* = $1,200 per iron condor sold if the value is $0.

The maximum loss for this trade is $3,800, calculated as the $50 wide maximum spread width (put and call spreads are the same width) - $12 net credit x 100* = $3,800 per iron condor sold. This maximum loss potential occurs if the price falls below $400 or rises above $600 (±20% stock price movement) at expiration, in 60 days.

The lower breakeven price for this trade is $438 ($450 put strike – $12 iron condor credit). At this price, the short $450 put will have $12 of intrinsic value at expiration, while all the other iron condor options will have expired worthless. This leaves you with a trade value of $12, the same amount you received for selling the iron condor initially, resulting in neither profit nor loss.

The upper breakeven price for this iron condor is $562 ($550 short call strike + $12 iron condor credit). At this price, the $550 call option will have $12 of intrinsic value at expiration, while the put side will expire worthless, mirroring the lower breakeven scenario.