Understanding Iron Condor

4.5

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In the previous chapter, we saw how you can leverage multiple different expiry months to earn profits using the calendar spread options strategy. In this one, we’re going to take a look at a market-neutral options trading strategy - the iron condor. Fancy name, isn’t it? So, let’s get on with it.

What is the iron condor?

As you’ve already seen above, the iron condor is a market-neutral trading strategy. What this essentially means is that this particular options strategy can be used when the market is neither trending up nor trending down. The iron condor is quite famous among traders since it can allow them to take advantage of low volatility market conditions.

While the strategy minimizes downside risks, it also tends to put a cap on the upside. Due to the innate nature of the iron condor, the strategy works best only when all of the options involved in it expire worthless.

How to set up an iron condor?

Setting up an iron condor trading strategy can be slightly challenging since it involves four different options - two calls and two puts. And so, this options trading strategy is better suited for experienced traders who have gotten the hang of the stock market. Here’s a brief look at what you would have to do to get an iron condor going.

  • Sell 1 lot of out of the money (OTM) put options
  • Sell 1 lot of out of the money (OTM) call options
  • Buy 1 lot of further out of the money (OTM) put options
  • Buy 1 lot of further out of the money (OTM) call options

When executing this strategy, make sure that you purchase all of the above-mentioned options with the same expiration date.

How does the iron condor work?

As usual, let’s take up an example to understand the concept of iron condor trading strategy better. Given below are some of the assumptions that we’re going to make. Ensure that you fully read and understand every single line item.

  • You’re interested in purchasing the stock of Britannia Industries Limited.  
  • However, the stock has been range bound and experiencing low volatility. 
  • Therefore, you decide to use the iron condor to take advantage of this situation. 
  • The shares of Britannia Industries are currently trading at Rs. 3,400. 
  • The lot size of the options contract of this stock is set at 200.
  • The expiry date of all the options that we’re going to consider would be May, 2021.

Now the iron condor trading strategy involves four different options with different intrinsic values, right? So, here’s what you would have to do in this example.

  • Sell 1 lot of OTM put options, which in this case would be BRITANNIA MAY 3300 PE. Let’s say that the premium for the put option is currently at Rs. 25 per share. Therefore, by selling 1 lot (which is 200 shares) of OTM put options, you would receive Rs. 5,000 (Rs. 25 x 200).
  • Sell 1 lot of OTM call options, which in this case would be BRITANNIA MAY 3500 CE. Assume that the premium for this call option is currently at Rs. 60 per share. So, by  selling 1 lot (which is 200 shares) of OTM call options, you would receive Rs. 12,000 (Rs. 60 x 200).
  • Purchase 1 lot of further OTM put options, which in this case would be BRITANNIA MAY 3200 PE. Let’s say that the premium for the put option is currently at Rs. 12 per share. So, to purchase 1 lot (which is 200 shares) of further OTM put options, you would have to pay Rs. 2,400 (Rs. 12 x 200).
  • Purchase 1 lot of further OTM call options, which in this case would be BRITANNIA MAY 3600 CE. Let’s say that the premium for the put option is currently at Rs. 30 per share. So, to purchase 1 lot (which is 200 shares) of further OTM call options, you would have to pay Rs. 6,000 (Rs. 30 x 200).

Now that you know what options contracts you need to purchase, let’s take a look at a few scenarios and see how the iron condor trading strategy performs in each of them.

Scenario 1: The stock price is between Rs. 3,300 and Rs. 3,500 on expiry

According to the iron condor strategy, you’ve basically sold two lots and bought two lots of options, right? The net amount you receive from this four-legged trade would be Rs. 8,600 [(Rs. 5,000 + Rs. 12,000) - (Rs. 2,400 + Rs. 6,000)]. Remember this.

Now, moving onto the scenario, if the share price of Britannia Industries falls somewhere between Rs. 3,300 and Rs. 3,500 on expiry, here’s what would happen. For this scenario, let’s assume that the share price on expiry falls at Rs. 3,450.

  • The OTM put options - BRITANNIA MAY 3300 PE that you sold would expire worthless since the price increased.
  • The OTM call options - BRITANNIA MAY 3500 CE that you sold would also expire worthless. This is due to the fact that the strike price is higher than the spot price and the buyer wouldn’t want to exercise such an option. 
  • The further OTM put options - BRITANNIA MAY 3200 PE that you bought would expire worthless since the price increased. 
  • The further OTM call options - BRITANNIA MAY 3600 CE that you bought would also expire worthless since the strike price is higher than the spot price.

Overall, the total net profit that you get to enjoy from this would be Rs. 8,600. With the iron condor strategy, you get to enjoy maximum profit when all of the options expire worthless.

Scenario 2: The stock price is below Rs. 3,300 on expiry

Alternatively, here’s what would happen if the stock price ends below Rs. 3,300 on expiry. Let’s assume that the stock expires at a price of Rs. 3,200.

  • Since the strike price is higher than the share price, the buyer would want to exercise his put option. Therefore, you would incur a loss of Rs. 100 per share on the OTM put options - BRITANNIA MAY 3300 PE that you sold. The loss from this trade would be Rs. 20,000 (Rs. 100 x 200).  
  • The OTM call options - BRITANNIA MAY 3500 CE that you sold would expire worthless. This is due to the fact that the strike price is higher than the spot price and the buyer wouldn’t want to exercise such an option. 
  • The further OTM put options - BRITANNIA MAY 3200 PE that you bought would expire worthless since the strike price is the same as the spot price. 
  • The further OTM call options - BRITANNIA MAY 3600 CE that you bought would expire worthless since the strike price is higher than the spot price.

Now, the total loss as a result of this strategy will be limited due to the net gain that you received through this four-legged trade. The total loss would come up to around Rs. 11,400 [Rs. 20,000 - Rs. 8,600].

Scenario 3: The stock price is above Rs. 3,500 on expiry 

Moving on to scenario 3, here’s what would happen if the stock price ends above Rs. 3,500 on expiry. Let’s assume that the stock expires at a price of Rs. 3,600.

  • The OTM put options - BRITANNIA MAY 3300 PE that you sold would expire worthless since the price increased.
  • Now, since the strike price is lower than the share price, the buyer would want to exercise his call option. Therefore, you would incur a loss of Rs. 100 per share on the OTM call options - BRITANNIA MAY 3500 CE that you sold. The loss from this trade would be Rs. 20,000 (Rs. 100 x 200). 
  • The further OTM put options - BRITANNIA MAY 3200 PE that you bought would expire worthless. 
  • The further OTM call options - BRITANNIA MAY 3600 CE that you bought would also expire worthless since the strike price is the same as the spot price.

Now, the total loss as a result of this options trading strategy will again be limited due to the net gain that you received through this four-legged trade. The total loss would come up to around Rs. 11,400 [Rs. 20,000 - Rs. 8,600].

Wrapping up

As you can see from the above scenarios, the iron condor strategy gives you maximum profits only when all four of the options expire worthless. This makes the options strategy the perfect choice for range bound stocks with minimal movement on either side.

A quick recap

  • The iron condor is a market-neutral trading strategy. 
  • What this essentially means is that this particular options strategy can be used when the market is neither trending up nor trending down. 
  • While the strategy minimizes downside risks, it also tends to put a cap on the upside.
  • To set up the iron condor strategy, you need to sell 1 lot of out of the money (OTM) put options and 1 lot of out of the money (OTM) call options, and buy 1 lot of further out of the money (OTM) put options and 1 lot of further out of the money (OTM) call options.
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