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neutral strategies

Iron Condors

Analyzing the risk profile of iron condors

Risk Profile & Summary

Standard Setup

The standard setup for an Iron Condor is to simultaneously
a
and a short OTM
of equal width. Typically, traders seek to collect a credit equal to about 1/3 the width of the
This creates a scenario in which they are risking 2 to make 1. The resulting position is
with risk above and below the profit zone, and a theoretical
between about 60 and 70%:
Risk Profile: Iron Condor

How It Works

Iron condors can be thought of most simply as two opposing
– 1
against 1
The two verticals in an iron condor are called "wings." Depending on the context, however, the term "wings" is also used refer to the
strikes alone (eg. "which wings did you buy?").
Iron condors are typically used by traders with a
Their goal is to capitalize on
decay as
and
The maximum potential profit of an iron condor is equal to the credit received and is attainable as long as the share price stays between the two
While in this range the options have the potential to expire worthless which would allow the trader to keep the entire credit.
Just like the other neutral strategies we've covered, iron condors carry risk both above and below their profit zone. If the share price breaches one of the short strikes, it will begin to take on
As you may recall from previous articles, intrinsic value does not decay. If the spread takes on an intrinsic value equal to the credit received, it will be at
To calculate the lower break-even, simply subtract the credit from the short put strike. To calculate the upper b/e, add the credit to the short call strike.
If the spread's intrinsic value grows larger than the credit, the position will be a loser. This is because, in order to close the position, the trader will be forced to pay a greater amount than they originally received. The maximum amount of intrinsic value that an iron condor can acquire is equal to the width of the widest wing.
To calculate the maximum potential risk of an iron condor, simply subtract the original credit from the width of the wings. For example, if you sold an iron condor for $1.50 and both of your wings are $5-wide verticals, then your max loss is:
$5 - $1.50 = $3.50
Keep in mind that, like any short option strategy, iron condors can show a
even while the share price remains in the profit zone. This would be caused by anything that increases the option values such as expanding
levels or the share price approaching one of your short strikes too quickly. There is, however, nothing to fear when this happens. As long as the share price remains between your break-evens the position will eventually become profitable by its expiration date.
Please revisit Pricing Options: Intrinsic & Extrinsic Value and Pricing Options: Time if you need a refresher on extrinsic value and premium decay.

Why We Do This

Neutral market bias is not the only reason a trader might
an iron condor. This strategy can be very useful for trading products that are too large or too risky to trade
Traders with smaller accounts might find this strategy particularly useful because it allows them to take more appropriately-sized risks in both cheap and expensive products alike. In many cases, it can also allow traders to reduce the
required to hold a position.

The Risks

Iron condors are defined-risk strategies which means the worst case scenario is made explicit at trade entry. There should be no surprises when it comes to the maximum loss potential. That said, never risk more than you are willing to lose on this strategy. Even though we can contain risk to comfortable levels, the odds that we actually experience the maximum loss is very high compared to a naked position. You WILL have some occasional maximum losers trading this strategy, so it is important not to risk more than you can afford to lose.
The number one killer of an iron condor is a fast, one-way market. By that I mean, the market moves huge in one direction and never reverts back. It can be very difficult to adjust iron condors for defensive purposes. Occasionally, there are a few tactics that can be utilized but, for the most part, the risks of this strategy should be accepted at trade entry. There's no guarantee that you'll be able to do anything to fix an iron condor gone wrong.
Another significant risk of this strategy is
Up until this point, none of the strategies we've covered have had more than two
Iron condors have four legs. Even in
markets, four legs can be tough to
at an ideal price. If your iron condor is a loser, it can be even more difficult to trade because the options will be
Options that are ITM typically have
which can make them significantly harder to
at a favorable price. You may be forced to pay much more than you'd like in order to close it.
Lastly, friction between the long and short strikes are another challenge to keep in mind when trading iron condors. Even though the long options help to contain the total risk, their decay works directly against the overall
This friction is most noticeable in iron condors that have their long strikes very close to their short strikes (in terms of delta). The long legs end up cancelling out much of the decay in the short options which creates a slow moving vehicle. Put simply, less risky iron condors will have a slower P/L and a lower POP. Higher risk iron condors will have a faster, more volatile P/L and a higher POP. As always, our mission as traders is to find a balance that fits our personal risk tolerance.

Summary

Assumption Neutral/Adaptable
Iron condors are usually thought of as neutral strategies which means they can profit if the share price stays within a specific range. They are, however, adaptable strategies and can be skewed in any direction to fit the traders assumption. Their directional risk can also change depending on how the share price moves.
Cost Basis Credit
The cost basis for an iron condor is equal to the total credit received.
POP Varying
An iron condor's POP can be altered by the amount of risk you choose to take relative to your potential reward. Risking more to make less typically correlates to a higher POP. Risking less to make more will result in a lower POP.
Capital Requirement Equal to Max Loss
The capital required for an iron condor is usually equivalent to the maximum potential loss. Low risk spreads result in lower capital requirements. High risk spreads result in higher capital requirements.
Break Even (before commission and fees) Iron condors have two break-evens. The lower b/e is calculated by subtracting the total credit received from the short put strike. The upper b/e is calculated by adding the credit received to the short call strike.

Lower B/E = Short Put Strike - Credit

Upper B/E = Short Call Strike + Credit
Maximum Profit Credit Received
The most you can make on an iron condor is the amount you sell it for.

Max Profit = Credit × 100
Maximum Loss Defined
To calculate the maximum potential loss of an iron condor, simply subtract the credit from the width of the widest wing. You can also use this calculation to find the risk on either side of the profit zone:

Upper Risk = Call Spread Width - Credit

Lower Risk = Put Spread Width - Credit
Capital Allocation (per position) 1-3% Max
Due to a relatively high probability of experiencing max loss and few defensive options, I typically don't like to risk more than 1 to 3% of my capital on iron condors.
Profit Target 25-50%
The goal is to cash out early with around 25-50% of the maximum profit.
Delta (P/L rate of change) Dynamic
Iron condors carry dynamic delta which means their delta will change as the share price changes. As the share price moves higher, the spread's delta will decrease and eventually become negative (bearish). As the share price moves lower, the delta will increase and eventually become positive (bullish).
Theta (Time decay) Positive, Reverisble
Properly established iron condors can generate moderate to high positive theta levels at trade entry. This means they benefit from the passage of time. The wider the wings, the greater theta will likely be. If your long and short strikes are too close to each other, they may begin to cancel each other out resulting a slower time decay rate. If the share price breaches one of the break-evens, theta can become negative. In this case, the passage of time will become disadvantageous to the trade.
Vega (Implied volatility sensitivity) Negative, Reversible
Properly established iron condors carry negative vega at trade entry. This means they benefit from decreases in implied volatility. If the share price gets close to one of your long strikes, however, vega can turn positive.
Gamma (P/L Momentum) Negative, Reverisble
Iron condors carry dynamic gamma which means their gamma changes depending on the juxtaposition of the strikes and the share price. Properly established iron condors carry negative gamma at trade entry (meaning it will slow into profit, and speed into loss). It can, however, become positive if the share price approaches one of the long strikes (meaning it will speed into profit, and slow into loss). Gamma will approach zero as the spread moves deep ITM (meaning its rate of P/L should remain more constant). It also approaches zero as the share price nears the center of one of the wings – this is the zone where vega can go from negative to positive, and vice-versa.

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