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Definition of 'Iron Condor'


Definition: Iron Condor is a non-directional option strategy, whereby an option trader combines a Bull Put spread and Bear Call spread to generate profit. In this strategy, there is a high probability of limited gain. An option trader resorts to this strategy if he believes that the market is going to be rangebound. The maximum profit in an Iron Condor strategy is equal to the net premium received adjusted for commissions. The maximum loss occurs when the price of the underlying security is higher than the strike price of the Long Call or when the price of the underlying security is less than the strike price of the Long Put.

Description: Iron Condor options involve the use of both Call and Put options to generate profit for the option trader. In a Call option trade, the two counter-parties involved are Call Option writer and Call Option buyer. The two parties have counter-views on the direction of the security price. The Call Option buyer believes that the price of the underlying security is going to rise while the Call Option writer believes that the price of the underlying security is going to fall.

Buying an option gives the buyer the right, but not the obligation, to acquire the security at a fixed price, called the Strike Price, within a certain date called the expiry date. If the Strike Price is less than the current market price of the underlying security, then the option is said to have an intrinsic value. This means that the option buyer will find it worthy to exercise his right. This scenario is also called in the money.

Scenario

1. Trade: Buy a Call

2. Option buyer’s outlook for the underlying security: Bullish

3. Risk: Limited

4. Reward: Unlimited

5. Break-even point: Strike price plus premium



In a Put Option trade, the counterparties remain the same as Call Option trade. But their views about the direction of the price of the underlying security change. The Put Option buyer believes that the price of the security is going to fall while the Put Option writer believes that the price of the underlying security is going to rise. If the strike price is more than the current market price of the underlying, then the Put Option is said to be in the money. This means it has some intrinsic value which makes it worthy for the Put Option buyer to exercise his right.

Scenario

1. Trade: Buy a Put

2. Option buyer’s outlook for the underlying security: Bearish

3. Risk: Limited

4. Reward: Limited

5. Break-even point: Strike price minus premium





Iron Condor option strategy is a limited risk-limited reward option trading strategy and can be seen as a combination of Bull Put spread and Bear Call spread. In a Bull Put spread, the option trader sells a Put option and at the same time buys a Put option at a lower strike price but with the same expiry. In this strategy, both risk and reward is limited. Increase in volatility typically hurts the option trader.



In a Bear Call Spread, the option trader sells a Call option and at the same time buys another Call option with a higher strike but with the same expiry. In this strategy, both risk and reward is limited.

In an Iron Condor option strategy, an option trader sells a Call option while at the same time buys another Call with a higher strike price. Simultaneously, he buys a Put option and at the same time buys another Put option at a lower strike price, but both expiring at the same time. Thus it’s a combination of both Bull Put spread and Bear Call spread.

In this strategy, the option trader believes that the market is neutral or rangebound. Both risk and reward in this strategy is limited. The maximum profit is attained when the stock price is between the strike price of the Short Put and Short Call. Time decay helps the options trader whereas an increase in volatility hurts position. Two break-even points are created in an Iron Condor option strategy.

1. Strike price in Short Call plus net premium received

2. Strike price in Short Put minus net premium received

The payoff diagram for a Condor options strategy is shown below



Let us take a scenario

Current market price of stock X: Rs 150

An option trader executes the following trades

1. Writes a Feb 2016 Call option at strike price Rs 160 and receives a premium of Rs 20

2. Buys a Feb 2016 Call option at strike price Rs 165 and earns a premium of Rs 20

3. Sells a Feb 2016 Put option at strike price Rs 140 and receives a premium of Rs 40

4. Buys a Feb 2016 Put option at strike price Rs 130 and earns a premium of Rs 30

The net premium received from the transaction

= 20-20+40-30 = 10

Assuming the stock trades at Rs 150 till the expiry of the option term, the maximum profit that the trader earns is equal to the premium received from the transaction. In this case, the maximum profit will be equal to Rs 10.

Now assuming that the stock price fell to Rs 130 before expiry, the option trader will benefit from the trade.

The following are the trading scenarios:


So in the above strategy, there is only one situation where the option is in-the-money or in other words, has an intrinsic value.
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