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What is an Iron Condor?

definition

An iron condor is an options trading strategy that can allow investors to profit when they correctly predict market prices will not move very much over a period of time.

🤔 Understanding an iron condor

Some people buy stocks because they hope to earn a profit when prices goes up. Others sell securities because they predict prices will fall and want to minimize losses. What about investors who think the market will pretty much stay put? One potential way they can earn a return is by setting up an iron condor. This is a type of active trading strategy that makes use of four options contracts — each of which allows the owner to buy or sell a specific security at a fixed price by an expiration date. The strategy gets its name from the diagram showing its potential profits and losses, which resembles a bird with wings outspread. Some traders like iron condors because they come with limited risks — but that can also mean limited potential profits.

example

Imagine that a hypothetical company called Condor Inc. is trading at $100 a share, and you believe the stock price won’t change much in the next couple of months. Here’s how you build your iron condor. You sell a call option with a strike price of $110 for a premium of $2 (the premium is the price you get for selling an option, which depends on several factors). Then you buy a call option with a strike price of $120, paying $1. The credit you make so far is $2 - $1 = $1. Notice that both of the call options strike prices are above the current market price.

Next, you carry out the other half of the iron condor. Let’s say you sell a put option with a strike price of $90 and get a premium of $2. You also buy a put option with a strike price of $80, paying $1. Notice that both of the put options strike prices are below the actual current share price. The credit is $2 - $1 = $1. All of the options expire on the same day, two months from the date you bought them.

So your total credit for both “wings” of the iron condor is $1 + $1 = $2. This is the maximum profit you can make per share. You only make this profit if all the options remain worthless, which means Condor Inc.’s share price has to stay above $90 and below $110.

Alternately, you can lose money if the stock closes anywhere outside the breakeven points ($88-$112). To calculate the maximum loss for an iron condor, subtract the credit received from the width of the widest spread. Keep in mind that both sides of an iron condor (the put and call side) typically have the same spread width. Let’s say when your options expire, Condor Inc. is trading at $115, which is beyond your highest call strike price. In this scenario, all the options would expire worthless, except the sold 110 call. The call option you sold loses $5 ($115 - $110). That means you lose $3 per share, after subtracting the $2 net credit you received plus commissions.

The above examples are for illustrative purposes only and do not reflect the performance of any investment or deduction of trading expenses and taxes. Investing involves risk, which means you could lose your money.

Takeaway

An iron condor is like the large bird it’s named after...

It can glide along smoothly if the market skies stay calm, providing investors with a welcome if limited return. Or it can swoop in unexpected ways if the market ends up more turbulent than expected, leaving them with potential losses.

illo 0018 iron-condor

Tell me more...

How does an iron condor trade work?
How can an iron condor make money?
How can an iron condor lose money?
How risky are iron condors?
What are the different types of condors?

How does an iron condor trade work?

It’s helpful to know a bit of vocabulary related to options trading before jumping into how an iron condor strategy works:

  • Remember than an option is a contract that allows you to buy (in the case of a call) or sell (in the case of a put) a security (often a stock or bond) at a certain price by the expiration date. When as an option owner you do the buying and selling, you are exercising the option.
  • The strike price refers to how much the owner of an option can buy or sell the underlying security for before it expires.
  • A call option allows you to buy the security at the strike price, and a put option allows you to sell it at that price.
  • A credit spread involves buying and selling options that are in the same class (call or put) and expire on the same day but have different strike prices.

An iron condor involves setting up two credit spreads, which make up the two “wings” of the bird:

  • A call spread means you buy one call option and simultaneously sell another call option. Both have the same expiration date, but one has a higher strike price than the other.
  • A put spread means you buy a put option and sell a put option at the same time. Again, both expire on the same day, but one has a higher strike price than the other. The difference in the strike prices (the spread) will under this strategy generally be the same as the one for the call options.

Usually, all of the options involved are “out of the money.” That doesn’t mean they’re broke! In the case of call options, it means they have strike prices that are higher than the actual price the underlying security is trading for. With put options, it means the strike prices are lower than the going market price for the security. Basically, that means the options have no intrinsic value on their own.

How can an iron condor make money?

So, if market prices are pretty much standing still, and you’re dealing with options that have no inherent value, how do you actually make money? The key lies in the “credit” part of “credit spread.” If the expiration date for the options arrives, and the price of the underlying security has barely budged, they’re all still worthless on their own. But if you bought a cheaper call option and sold a more expensive one, the difference leaves you with a credit. Similarly, if you buy a cheaper put option and sell a more expensive one, you get to keep the credit.

How can an iron condor lose money?

Getting maximum profit from an iron condor requires your options to remain without value of their own — that is, you are counting on the market not to move too much. If the market price fluctuates more than you expect and gets close to or beyond your window, that would either cut into your profits or cause you to take a loss.

The good news is that, just like there’s a ceiling to how much you can make with an iron condor, there’s a floor to how much you can lose. You give up the most if the price actually goes above your higher call strike price or below your lower put strike price.

How risky are iron condors?

Iron condors are rather popular among active traders. Some see them as a potential way to generate a pretty reliable return with limited risk. By definition, you can’t see losses on both credit spreads at the same time. Therefore, there’s a limit to how much you can lose. Compared to other option strategies, they also don’t require as much time and effort in terms of making trades. Still, there is always the chance you’ll lose money if stock prices don’t behave as expected.

One potential way to help manage risk is to trade options on index funds such as exchange traded funds (ETFs), which include a portfolio of securities from a bunch of different companies that are all part of a specific index. For example, an S&P 500 ETF includes the 500 biggest companies listed on U.S. stock exchanges, and the Russell 2000 is made up of small-cap company stocks. While a single company’s stock can change wildly in a short period in response to events inside or outside the firm, an ETF is less likely to be as volatile since it includes many different companies.

Keep in mind, options trading has significant risk and isn’t appropriate for all investors — and certain complex options strategies carry even additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. There are additional costs associated with options strategies that call for multiple purchases and sales of options as compared with a single option trade. Investors should absolutely consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.

What are the different types of condors?

There are a few different trading strategies related to iron condors:

  • A condor: While an iron condor uses both call and put credit spreads, a condor uses just one class of options. A long condor aims to make a profit when stock prices are expected to stay stable, and a short condor earns a return when the underlying security makes a big move up or down. Both long and short condors can use either calls or puts, but they always use just one of them at a time.

  • A reverse iron condor: A regular iron condor earns a profit when the underlying stock price stays stable. A reverse iron condor does the opposite — It’s designed to earn a return when the stock price takes a sharp turn up or down, especially if you don’t know which way it’ll go. You can set up a reverse iron condor by buying an out-of-the-money put option at a lower strike price and selling one at an even lower strike price. At the same time, you buy an out-of-the-money call option at a higher strike price, and sell one at an even higher strike price. Again, the expiration dates are the same on everything. At the beginning, you’re in the red. You make money if the stock price goes lower than the put option you bought or higher than the call option you bought.

  • An iron butterfly: Like the iron condor, this is another options trading strategy that relies on both calls and puts and bets on prices staying stable. The main difference is that the iron butterfly has a narrower range, meaning that it has the potential to produce higher returns, but the probability of earning a profit is lower.

Keep in mind, options trading has significant risk and isn’t appropriate for all investors — and certain complex options strategies carry even additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should absolutely consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.

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