Stocks and bonds are popular tools for investment, and similar to these securities is an ‘option’. An option is a contract with strictly defined terms and conditions which gives the buyer the right to buy or sell an underlying asset within a specified period and at a specific price.
Option trading has many strategies. ‘Iron Condor’ is one such strategy which involves four different options with four different strike prices. It employs the use of two vertical spreads: a ‘put spread’ and a ‘call spread’. Both have the same expiry date. An iron condor can be both long and short depending on the holding position, each having a contrasting strangle strategy. Long iron condor is the simultaneous selling of OTM (Out of The Money) put and call spreads. It sells both sides of the underlying instrument covering each position, after shorting the same number of calls and puts, by purchasing further OTM call(s) and put(s) respectively. A short iron condor employs the same tactics but in the opposite direction.
The profit/loss graph derived from the trading strategy loosely resembles a large-bodied bird like the condor, from which the position derives its name. Following the shape of the bird, traders refer to the ‘wings’ as inner options and the ‘wings’ as a representation for outer options. Similar to the concept of an ‘iron butterfly’, the term iron in the name ‘iron condor’ refers to the construction of the position using both calls and puts through the combination of a bull put spread with a bear call spread. Despite the fact that a long iron condor is “long”, it (and the long iron butterfly) become a credit spread due to the combination of the bull put and call spreads. It is distinguishable from a plain Condor position (and the plain Butterfly), which is constructed through either combination possibilities of the two spreads. It can be either all calls, all puts, combination of a bull call spread with a bear call spread or the combination of a bull put spread with a bear put spread. A (usually small) net debit is entered for the overall position of the long plain Condor (and Butterfly) because of the combination of a debit spread with a credit spread.
Many would then ask, what’s the advantage of investing in an iron condor over a single vertical spread (a put spread or call spread), especially since the initial and maintenance requirements are, most of the time, the same? One of the practical advantages here lies in the profit potential offered by an iron condor which is that of two net credit premiums instead of only one. When the trader doesn’t expect the spot price of the underlying instrument to change significantly, this can improve the potential rate of returns significantly on the amount of capital risked.
An iron condor has another advantage for traders in avoiding additional transactions by letting the expiry date of some or all of the options contracts pass. This can happen only if the underlying instrument’s spot price is between the inner strikes towards the end of the option contract. At times the trader may be concerned about the pin risk or the closeness of the inner strikes with the spot price of the underlying. In such cases they can first re-purchase the written options and then sell the purchased options which can end up closing one or both sides of the position.