The Iron Condor is an options trading strategy that relies on low volatility to create a non-directional position with limited risk and limited profits.
Establishing an Iron Condor
An options trader establishes an Iron Condor position by selling an out of the money put option, buying an out of the money put option with an even lower strike price, selling an out of the money call option and buying an out of the money call option with an even higher strike price.
The goal of the Iron Condor is to profit from selling both a call option and a put option of a low volatility security. The purchase of the further out of the money put and call options are to act as a safeguard against extreme price swings.
Iron Condor Example
Take a security that is trading at $45.
The trader sells a put at a $40 strike price and a call at a 50$ strike price. This is the core of the Iron Condor position. The trader has a low expectation of volatility, so it is unlikely that the security will fall below $40 or rise above $50 for the duration of the trade.
However, to guard against extreme payouts, the trader also purchases a call at $55 and a put at 35$. Although these safeguards will eat into the trader’s final profit, the premium paid will be lower than the premium received from selling the original call and put, as they are further out of the money.
Ideally all the options will expire worthless with the market price never exceeding $50 or falling below $40. However, the trader has a safeguard at both $55 and $35 to ensure that any losses from unexpected volatility will be capped.
Trading with an Iron Condor
Selling options is risky due to the unlimited potential losses when trades move severely against the original position. Even worse, the seller of an option has no ability to exit a losing trade, and must wait for the counterparty to decide when to close the position.
Therefore, many options sellers choose to limit their losses by purchasing offsetting options. While these offsetting options may eat into their potential profits and lower the profitable window for their trade, they guard against the extreme outcomes that can occur from options selling.
Even in the case of the Iron Condor, which is fundamentally a safe trade based on a low volatility security, the potential downside from a severely bad trade is enough to warrant the added security from purchasing options that are even further out of the money.
The Iron Condor is a sophisticated options trading strategy that takes advantage of low volatility securities in the attempt to extract a relatively small profit from selling options. The potential downside of options selling is then further reduced by purchasing offsetting options that serve to act as a cap on potential losses, even though the purchase of these offsetting options will reduce the potential profit from the trade.
The Iron Condor is an example of the potential safety that can be assured by the establishment of complex positions in the options market using multiple offsetting options contracts.