There is no more commonly traded strategy than the “Iron Condor” when it comes to options trading. Frequently used in traders’ portfolios, an Iron Condor can be considered a combination of both credit spreads and directional bearish bets.
However, despite its popularity amongst options traders due to its flexibility and high probability of success when using strategies such as hedging and straddles, it is often only dealt with superficially by most market professionals due to its more involved mechanics. Because of this, many new or inexperienced investors may struggle with the intricacies associated with this complex investment vehicle.
The two main aspects of Iron Condor:
Two main aspects make up an Iron Condor trade; buying multiple option contracts (to construct the “spread”) and selling one option contract (to establish the “credit”). To better understand how Iron Condors work, let’s look at an example.
Example
Assume you are bullish on XYZ stock but want to hedge your position with a trade that has a high probability of success. You could buy a call option at $50 with an expiration date four weeks away and sell a put option at $45 also with an expiration date four weeks away. It would create what is known as an “Iron Condor” trade. Because you are buying one option contract and selling another, this is also considered a “spread”.
This trade has the potential to be successful because it is constructed with two “boundary” prices. The first boundary is the price at which you bought the call option, and the second is the price at which you sold the put option. As long as XYZ stock remains between these two prices (or “bounds”), your trade will be profitable.
So why is an Iron Condor such a widespread trade?
There are a few reasons:
- As we mentioned earlier, it is a relatively low-risk trade due to its high probability of success.
- It offers traders a great deal of flexibility; you can remain bullish or bearish on the underlying stock while still profiting from the trade.
- Because an Iron Condor comprises two spreads (a buy and sell), allowing investors to take on directional bets while still collecting a credit.
It makes it a great “starter strategy” for beginners to test the waters with, as it lets you take advantage of the benefits that come from multiple trades.
What’s the downside?
The first and most obvious risk is that any movement outside your chosen bounds will cause you to lose money on the trade. The second major drawback is that Iron Condors can be rather costly to hold because two options must be constantly monitored and re-adjusted as they approach their expiration date. This cost increases exponentially if enough time passes between adjustments and when more than one adjustment must be made during a single expiration period.
Generally speaking, Iron Condor trades work best when there is low volatility in an underlying stock or index; this lower volatility leads to smaller price swings and a tighter trading range. When volatility is high, the price of options tends to increase (and vice versa), making it more difficult and expensive to construct an Iron Condor trade.
In conclusion
Iron Condors are an excellent way for investors to take advantage of a relatively low-risk trade with a high probability of success. Using this strategy, you can remain bullish or bearish on stock while still profiting from directional bets. However, it’s important to note that this trade does come with some risks, namely that any movement outside of your chosen bounds will cause you to lose money on the trade.
Additionally, because two options must be constantly monitored and re-adjusted as they approach their expiration date, Iron Condors can be rather costly to hold. For these reasons, it’s best to use this strategy when there is low volatility in an underlying stock or index.
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