What is an Iron Condor?
In options trading, the iron condor strategy is a neutral approach that combines a bullish and bearish vertical spread on the same underlying asset and comes with controlled risks and profit.
To understand why iron condors appeal to certain investors, let's explore what they are, how traders construct them, and the potential risks and rewards they offer.
Iron condor is an options strategy that combines put and call vertical spreads to create a range of strike prices that achieves maximum profit if all four options expire worthless.
The iron condor strategy is designed to help a trader profit from minor movement in either direction in the market, or preferably no movement at all. Depending on the combination of options (call or put), the strategy can benefit from both low and high volatility.
How to Set Up an Iron Condor
By default, the iron condor refers to the short iron condor, in which volatility is sold when there’s minimal movement in either direction in the market. It’s structured to combine both a bull put spread and bear call spread, and comes with controlled risks and profit.
The name "iron condor" is derived from the shape of the profit-and-loss (P&L) graph it produces, which vaguely resembles the body and wings of a large bird. The image below is a basic representation of the P&L diagram of a short iron condor.
Source: Options Playbook
The spread has four positions (two calls and two puts) and four strike prices with the same expiration date. Here’s how it’s set up:
Buying one ATM or OTM put below the current price
Selling one OTM put above the current price
Selling one OTM call above the current price
Buying one ATM or OTM call below the current price, preferably equidistant to the long OTM put
Different types of iron condor spreads arise depending on the strike prices of the put and call options, which determine whether the strategy leans bullish or bearish.
Long Iron Condor vs. Short Iron Condor
While the iron condor features short volatility or movement, the reverse iron condor (AKA, long iron condor, inverse iron condor) features long volatility or movement.
The reverse iron condor benefits from an increase in IV or a large price movement in either direction. It’s also a combination of two puts and two calls, but this time in a reversed manner.
Here’s how the setup works:
Buy one OTM put
Sell one OTM put above the long OTM put
Buy one OTM call
Sell one OTM call below the long OTM call
The reverse iron condor is used when there’s a bias for notable price movement in anticipation of high volatility. Profit is recorded if the underlying asset:
1) Closes above the upper OTM strike price at the time of expiration, or
2) Closes below the lower OTM strike price at the time of expiration.
In traditional finance, a debit is paid to open a short iron condor strategy. It has limited risk: In the worst-case scenario, a trader would only lose the premium paid. On the other hand, the long iron condor is constructed with two debit spreads. Therefore, a significant price change and/or an increase in IV is required before expiration to profit from this setup.
Additionally, time decay works against the short iron condor strategy as it will affect both the long options. For that reason, long iron condors are used much less frequently than short iron condors, where time decay works for traders.
Investors could aim to open a long iron condor if they believe a specific stock price will significantly move in either direction before expiration.
Option Strategy Comparisons (Iron Condor vs. Other Strategies)
Iron Condor vs. Iron Butterfly
Source: Options Playbook
Iron condors and iron butterflies are similar options strategies. Both profit by selling volatility and use long positions to limit risk. However, the maximum profit zone for an iron condor is much wider than that of an iron butterfly, and the trade-off of an iron condor is lower profit potential.
An iron butterfly sells a put and call option at the same strike price (usually ATM) and buys two OTM put and call options. It is highly likely that one of these contracts will go in the money (ITM), since it just needs to move one strike away from the current price. The benefit of the iron butterfly is that it allows you to charge a high premium for each contract, since they’re ATM. This strategy is worth implementing if you’re confident that prices won’t move much.
Maximum Loss = Difference Between ATM and OTM Strike Price − Net Premium Received
Maximum Profit = Net Premium received when prices don’t deviate from the current price.
Iron Condor vs. Credit Spread
Source: Options Playbook
A credit spread is a strategy that involves selling an option and, simultaneously, buying a lower value or further OTM option in order to earn the premium, as long as the price does not move beyond the outer strike price option.
An iron condor is essentially a double-sided credit spread. Because it’s double-sided, the iron condor can provide a larger credit, but it also comes with the risk of loss if the price goes too much in either direction.
Similar to an iron condor, traders' maximum profit is the net premium when using a credit spread. The maximum loss is the difference between the strike prices and the premium received.
Maximum Loss = Difference Between Strike Prices − Net Premium Received
Maximum Profit = Net Premium Received
Who Is the Iron Condor Strategy For?
The iron condor spread is an intermediate-to-advanced strategy because of its controlled risk and profit and the complexity of setting up four positions with different strike prices. It’s the combination of a bull put spread and bear call spread to sell volatility, comes with controlled risks and profit, and has the flexibility of leaning bearish or bullish.
This flexibility means that an intermediate trader will benefit from technical analysis. This will help them know which strike prices to set to best maximize the expected value from their trade, rather than only doing a purely neutral setup. Therefore, this strategy is better suited for intermediate traders who can take advantage of neutral, bearish and bullish environments to sell volatility.
Unlike other advanced strategies such as short strangles, where you can incur significant risk, the downside risk of the bear put spread is capped.
When to Use Iron Condor
The short iron condor is activated when there's no bias on the direction, but a bias on volatility that remains constant or decreases. Traders will opt for this strategy if they foresee minimal price movement on the asset. An example of a period with minimal price movement could be after a large price move due to news. Following a high-volatility event, the asset enters a consolidation period.
The long iron condor strategy is activated when there's no bias on the direction but a bias on increasing volatility. A trader could use a long iron condor to anticipate a big event or piece of news, such as a consumer price index (CPI) inflation number, where the trader believes the markets will move significantly after the news, but is unsure whether it will be up or down.
As the iron condor is a neutral strategy, there are two breakeven points. For a short iron condor, the breakeven points can be calculated as follows:
Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put − Net Premium Received
For a long iron condor, the breakeven points can be calculated as follows:
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put − Net Premium Paid
A loss on an iron condor will be realized if the underlying asset price closes outside one of the two breakeven prices.
Iron Condor Sweet Spot
The goal of an iron condor is usually to capitalize on the money you earn from time decay, the drop in volatility, or a combination of the two. If the underlying stock price stays between the short options at expiration, the contracts will expire worthless, and the original net credit received will serve as profit.
However, this doesn’t necessarily mean the investor has to wait until expiration to profit from the strategy. If the strategy is already in profit since volatility has dropped a lot, or the time value has decayed significantly, it may be a good opportunity to close the position for a profit: Buy back the short options, exit either the call or put side of the iron condor, or exit the full position. Doing so means the trader will receive less than the maximum profit potential. However, it also prevents a last-minute tail risk move in the underlying asset's price due to unforeseen events.
With each passing day, the time value of an options contract decreases. This time decay works to the advantage of an iron condor trader, as it turns into unrealized profits. Additionally, if the underlying asset has minimal price movement, volatility is expected to drop, causing the short options to lose value as expiration approaches.
Adjustments to Make in Bearish Markets
In the event that volatility increases again, or the option moves in one direction aggressively and is outside your range, you can close your iron condor and open it to a new price range — the caveat being that you need to accept some losses.
If a trader believes that this significant price change is only temporary, and that it will eventually return to its previous price range in due time, a trader can choose to close the iron condor and open it at the same price range — but with a later expiration date.
Maximum Take-Profit Potential
The maximum profit for an iron condor is the difference between the premium received and the premium paid. Profit is achieved constantly if the price remains the same and time passes, known as Theta decay. Profit is gained if volatility drops as well.
A common take-profit target for an iron condor is 40-60%, as it isn’t necessary to wait until the option fully expires.
Maximum Profit = Net Premium Received
Maximum Incurred Loss Potential
The maximum loss potential is calculated as the difference between the strike prices of either spread and the premium received.
Losses are reduced constantly if the price remains the same and time passes, known as Theta decay. However, losses are gained if the price goes out of the range of the inner strikes. Losses are gained if the volatility goes up as well.
Maximum Loss = Difference between Inner and Outer Strike Price − Net Premium Received
Iron Condor Example
Let's put everything together and craft an example scenario using sample numbers.
Let's presume that Bitcoin is trading for around $20,000 after a huge volatility event, and its IV is elevated above its historical averages.
If you think that the price of Bitcoin will stay around the $20,000 mark, and that BTC’s volatility will decrease within 30 days, you can set up an iron condor.
To do so, you can sell a put option contract with a strike price of $19,000 expiring in 30 days for a credit (gain) of $1,000, and buy a put option contract with a strike of $18,000 expiring at the same time for a debit (cost) of $700. You can also sell a call option with a strike price of $21,000 for a credit of $1,000, and buy a call option with a strike price of $22,000 for a debit of $700. (These would both be at the same expiration date as the put spreads.)
In this case, you’ll earn a total maximum profit of $600 to set up this strategy ($1,000 − $700 + $1,000 – $700), as long as Bitcoin stays within $19,000 and $21,000 upon expiration. Your maximum loss will be $400 ($1,000 − $600) if Bitcoin’s price goes outside of the outer strike prices on expiration.
Iron Condor Tips
One trading strategy tip for an iron condor options strategy is to set it up after a high-volatility event, when volatility typically drops significantly; this is known as an “IV crush.” As it’s not necessary to hold an iron condor position until expiration, a trader may close the position for a larger profit in just a short period of time, long before the expiration date.
Two types of margin trading — regular margin (RM) and portfolio margin (PM) — are available on Bybit, with RM serving as the default mode for all options-related transactions.
RM prevents liquidation by utilizing the trader’s total available balance within the trading pair (e.g., BTC options), while PM combines the positions of the futures and options portfolios to calculate user margin.
Theta Decay Impact
Theta refers to how much time decay affects the total value of a position. For every asset, the total value reduces in relation to the proximity of the expiration date (i.e., the closer a position gets to its expiration date, the lower its value becomes).
Theta works for the iron condor spread. This means an iron condor spread has a positive Theta, since the trader earns money as time passes.
Implied Volatility Effect
Since the actual volatility of an option can't be predicted before entering a position, the assumption or calculation of implied volatility (IV) is a consideration in options trading. Volatility shows how much an asset price fluctuates in terms of percentage. In options, as volatility increases, the price of an option rises with it when other factors remain constant.Vega is the technical term that represents volatility.
With long options, a trader makes money from an increase in volatility, while with short options, a trader loses money when volatility increases. The reverse is the case when volatility decreases.
Therefore, short iron condors benefit from a decrease in IV. On the other hand, long iron condors benefit from an increase in IV.
Iron condors allow you to trade with a neutral bias, with the flexibility to create a large buffer to reduce the stress and risk of losing money — something that many traders will no doubt appreciate. This options strategy also allows traders to own positions with limited risk and a high probability of success.
The iron condor strategy has limited downside risk because it hedges the options that are written (sold) to protect against significant moves in either direction. However, every option strategy has trade-offs: The lower the risk involved, the lower the profit potential.
A few alternatives to the iron condor are the long call butterfly strategy, the iron butterfly and the short strangle strategy, all of which benefit from minimal movement.
Iron condor is an options strategy that aims to take advantage of an expected decrease in price movement, essentially shorting volatility. It shines brightest when there’s little to no price movement from the underlying asset due to the time decay of options, achieving maximum profit when all options expire worthless.