Iron Condor: what is it and how does it work?

Options trading is exciting, but equally challenging, especially for beginners. The Iron Condor is one of the many strategies available to profit from markets that are relatively stable. In this article, we'll explain what the Iron Condor is, how it works, and how to profit from it.

iron condor option strategy

What is an Iron Condor? | An options strategy

The Iron Condor is an options strategy ideal for investors or traders who hold a neutral market outlook, making it a Delta-neutral strategy. This approach offers a chance to profit in sideways or range-bound markets, particularly during periods of high implied volatility with a potential for decline at a foreseeable moment.

A key advantage of the Iron Condor is its benefit from the passage of time, as it remains largely unaffected by price movements provided the market stays within the predetermined range until the options expire. Unlike the Short Strangle strategy, the Iron Condor features limited and predetermined losses, adding a layer of risk management for the investor.

Profit and loss graph of an Iron CondorCondor with open wings

As you can see in the figure above, it is named Iron Condor because the graph representing the profit-loss relationship resembles a bird with large open wings.

How is the Iron Condor formed?

An Iron Condor consists of two puts, one long and one short, and two calls, one long and one short, four strike price, and all have the same expiration date and the same underlying asset.

  1. Buy a put option with a lower strike price (price A)
  2. Sell a put option with a higher strike price (price B)
  3. Sell a call option with a higher strike price (price C)
  4. Buy a call option with an even higher strike price (price D)

For a standard Iron Condor, the relationship between the strike prices is A < B < C < D. It’s important to note that the put options (A and B) are typically out-of-the-money, and the call options (C and D) are also out-of-the-money. This setup creates a range within which the underlying asset’s price can fluctuate without causing a loss at expiration, as long as it remains between prices B and C.

Types of Iron Condor

There are two types of Iron Condor:

  • Standard Iron Condor (also referred to as a short Iron Condor)
  • Long or reverse Iron Condor (less common)

In options trading, the Iron Condor is inherently a “short” strategy, meaning it involves selling options. It consists of a short call spread and a short put spread, and it is designed to profit from the underlying asset's price staying within a specific range (between the strike prices of the sold options). The strategy benefits from time decay and low volatility, with the ideal scenario being that all options expire worthless, allowing the trader to keep the premium received.

The reverse or long Iron Condor is a less common variant. It is essentially the opposite of the standard Iron Condor. In this strategy, a trader buys both a call spread and a put spread (buying the outer options and selling the inner options). The goal is to profit from a significant move in the price of the underlying asset, either up or down, beyond the strike prices of the sold options. This strategy has a higher potential reward compared to the standard Iron Condor but requires a more significant price movement to be profitable.

Terms you should know to understand the Iron Condor

As mentioned above, the Iron Condor consists of a short call spread and a short put spread.

Short call spread

A “short call spread,” also known as a “bear call spread,” is a type of options trading strategy that involves simultaneously selling and buying call options with the same expiration date but different strike prices. The strategy is used when a trader expects the underlying asset's price to fall or remain relatively stable. Here's how it works:

  1. Selling a call option: The trader sells a call option at a certain strike price. This is typically an out-of-the-money call, meaning the strike price is above the current market price of the underlying asset. By selling this call option, the trader receives a premium (the price of the option).
  2. Buying a call option: At the same time, the trader buys another call option on the same underlying asset with the same expiration date but a higher strike price. This option is further out-of-the-money. The premium paid for this option is less than the premium received from selling the first call option.
  3. Profit and loss: The maximum profit of this strategy is limited to the net premium received (the premium received from selling the first call minus the premium paid for the second call). This maximum profit is achieved as long as the price of the underlying asset stays below the strike price of the call option sold. The maximum loss is limited and occurs if the price of the underlying asset rises above the strike price of the call option bought. The loss is the difference between the two strike prices minus the net premium received.

Short put spread

A “short put spread,” also known as a “bull put spread,” is an options trading strategy that involves selling and buying put options on the same underlying asset with the same expiration date but different strike prices. This strategy is used when a trader expects the underlying asset's price to rise or remain above a certain level. Here’s a breakdown of how it works:

  1. Selling a Put Option: The trader sells (or writes) a put option at a certain strike price. This is typically an out-of-the-money put, meaning the strike price is below the current market price of the underlying asset. By selling this put option, the trader receives a premium.
  2. Buying a Put Option: Simultaneously, the trader buys another put option on the same underlying asset with the same expiration date but a lower strike price. This option is further out-of-the-money. The cost of buying this put option is less than the premium received from selling the first put option.
  3. Profit and Risk: The maximum profit of this strategy is the net premium received (the premium from selling the first put minus the cost of buying the second put). This maximum profit is achieved as long as the price of the underlying asset remains above the strike price of the put option sold. The maximum loss is limited and occurs if the price of the underlying asset falls below the strike price of the put option bought. The loss is the difference between the two strike prices minus the net premium received.

In the context of an Iron Condor, the short put spread forms one part of the strategy (similar to one “wing” if you visualise it on a profit/loss graph). It is designed to profit from the underlying asset not falling below the strike price of the sold put option, complementing the short call spread on the other side of the Iron Condor. The combination of these two spreads creates a position that profits from stability in the underlying asset's price within a certain range.

Example of an Iron Condor strategy

Let's assume the current price of a hypothetical stock is £100.

Short put spread:

  • Sell a put option with a strike price of £98 (Price B) for a premium of £1 (received).
  • Buy a put option with a strike price of £96 (Price A) for a premium of £0.50 (paid).

Short call spread:

  • Sell a call option with a strike price of £102 (Price C) for a premium of £1 (received).
  • Buy a call option with a strike price of £104 (Price D) for a premium of £0.50 (paid).

Net premium received:

  • From selling put and call options: £1 + £1 = £2
  • From buying put and call options: £0.50 + £0.50 = £1
  • Total net premium received: £2 – £1 = £1

Ideal scenario for maximum profit:

  • At expiration, the stock price should be between £98 and £102. If so, all options expire worthless, and you keep the net premium of £1.

Maximum loss:

  • If the stock falls below £96 or rises above £104. The maximum loss is the difference between the strike prices of the bought and sold options in either spread, minus the net premium received.
  • For the put spread: £98 – £96 = £2. For the call spread: £104 – £102 = £2.
  • Maximum loss per spread: £2 – net premium received (£1) = £1. However, only one spread can hit its maximum loss, so the total maximum loss is £1.

Outcome analysis:

  • If the stock stays between £98 and £102, you make a profit of £1.
  • If the stock moves significantly outside this range, your loss is capped at £1.
  • The Iron Condor strategy in this scenario profits from time decay and limited movement in the stock's price.

Spread width

For the put spread, the spread width is calculated by subtracting the lower strike price from the higher strike price. So, £98 (sold put) – £96 (bought put) = £2.

For the call spread, the spread width is also the difference between the strike prices. So, £104 (bought call) – £102 (sold call) = £2.

The spread width directly impacts the maximum potential loss of each spread. In this case, the maximum risk for each spread (put and call) is the spread width minus the premium received for that spread.

In this example, if the spread width is £2 for both the call and put spreads, and assuming you receive a net premium (after costs) for setting up each spread, the maximum risk for each spread is £2 minus that net premium.

While each spread has its own risk profile based on its spread width, remember in an Iron Condor, only one side (either the call spread or the put spread) can face the maximum loss at expiration, not both simultaneously. This is because the stock price cannot be both above £104 and below £96 at the same time. Therefore, the total maximum risk of the Iron Condor is capped to the spread width of one side minus the total net premium received.

A wider spread may increase your chances of making profit, but also increases the maximum loss.

Options trading may seem challenging, but with one of the best brokers for options, you can easily test these strategies in a demo account to get experienced before risking real cash.

Pros and cons of applying the Iron Condor

Let's now see the advantages and disadvantages of applying the Iron Condor:

Pros of applying the Iron Condor

  • ✅ Ideal for relatively stable markets
  • Basic strategy ideal for beginners
  • ✅ Easy to implement
  • ✅ High chances of profits in stable markets
  • ✅ Can be automated

Cons

  • ❌ As with other derivatives, it's a risky strategy
  • ❌ Volatility, transaction costs, and other factors affect your profit
  • ❌ Not suitable for trending markets

Strengths of the Iron Condor:

  • The market moves sideways about 70% of the time. In addition, any abrupt movement tends to be corrected and the market usually returns to its average, which makes a strategy of this type have a high probability of success.
  • In-depth knowledge is not necessary. Although, like everything in trading, a robust strategy and proper risk management are needed.

Weak points:

  • Although it does not require in-depth knowledge or analysis techniques, it does require a deep understanding of market volatility, trends, options, and premiums.
  • It does not take advantage of major trends.

Is the Iron Condor the best options strategy?

Like any strategy involving options, the effectiveness of an Iron Condor largely depends on specific market conditions. It's essential that these conditions align well with the strategy's requirements for it to be successful.

Having knowledge of the Iron Condor strategy can be a valuable addition, often considered a near necessity. However, whether to apply it depends on the individual trader’s goals, risk tolerance, and market outlook.

The Iron Condor strategy offers considerable versatility, thanks to its adaptability to various time frames and its ability to capitalise on different market scenarios. These include:

  • The natural passage of time (time decay)
  • Anticipated collapses in volatility
  • Increases in implied volatility surrounding data releases
  • Expected market movements

To implement the Iron Condor strategy, a trader must use a brokerage platform that allows the buying and selling of options. DEGIRO, for instance, offers competitive costs. Read our DEGIRO review for more information. There are always plenty of strategies to carry through, like the wheel strategy or the straddle, so choose according to your financial objetives.

Learn more about derivatives

Summary

In conclusion, the Iron Condor strategy stands out as a sophisticated yet effective approach in options trading, particularly appealing to those seeking to capitalise on range-bound markets.

Its structure, involving the simultaneous selling and buying of put and call options, creates a defined risk-reward scenario, making it a preferred choice for traders who prioritise balance and stability.

FAQs

When should I use an Iron Condor strategy?

The Iron Condor is best used when you expect the underlying asset to have low volatility and remain within a specific price range. It’s ideal for markets that are not exhibiting strong bullish or bearish trends and are expected to stay relatively stable. This strategy is often employed when there is no significant news or events anticipated that might cause large price swings.

Can I adjust an Iron Condor once it's set?

Yes, adjustments can be made to an Iron Condor if the market moves against your position. Common adjustments include buying back the threatened spread (call or put) and selling another with a further out strike price or expiration date. These adjustments aim to manage risk and salvage the position but will impact the potential profit and loss. It's important to have a clear adjustment plan before entering the trade, as making adjustments can sometimes increase complexity and trading costs.

How do I select strike prices for an Iron Condor?

Choosing strike prices for an Iron Condor involves balancing risk and potential return. Typically, traders select out-of-the-money strike prices for both the call and put spreads. The distance between these strike prices and the current price of the underlying asset should reflect your market outlook and risk tolerance. Wider spreads between strike prices can offer higher premiums (more potential profit) but also more risk, while narrower spreads tend to have lower risk and lower potential profit.

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