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On Options

Short Iron Condor Spreads: Understanding the Basics

Learn how short iron condor spreads can be used as a neutral strategy when you expect a stock or ETF to remain in a narrow trading range.

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A short iron condor, which is typically used as a neutral strategy, involves four legs and four different strike prices established in a 1/1/1/1 ratio. Unlike traditional condors which can be created using calls or puts, iron condors are created using both calls and puts at the same time.

A short iron condor is a neutral strategy that has a limited loss potential if the underlying security moves sharply in either direction. An iron condor is considered "short" if a net credit is received when it is initiated:

  • Buy one put with the lowest strike price
  • Sell one put with a higher strike price
  • Sell one call with a higher strike price
  • Buy one call with the highest strike price
Basics of a short iron condor spread
Figure 1: Basics of a short iron condor spread
Source: Schwab Center for Financial Research

The options chosen for an iron condor should all have the same expiration date and the strike range between the first and second leg should be the same as the strike range between the third and fourth leg. Like many option strategies, the maximum gain, maximum loss, and breakeven points can all be calculated at the time of order entry.

How to calculate price levels for a Short Iron Condor

Assuming stock ZYX is trading at 156.46, the following formulas will allow you to calculate the maximum gain, maximum loss, and upper and lower breakeven prices on any short iron condor trade.

Example of a 10-point short iron condor spread:
Buy 10 ZYX Feb 140 puts @ 1.15
Sell 10 ZYX Feb 150 puts @ 2.89
Sell 10 ZYX Feb 160 calls @ 2.91
Buy 10 ZYX Feb 170 calls @ 0.70 
CR (Credit) = 3.95 (-1.15 + 2.89 + 2.91 - 0.70)
MG (Maximum Gain) = 3.95 (Credit received x number of spreads) or $3,950 (Occurs between the second and third strike prices)
ML (Maximum Loss) = 6.05 (first strike – second strike + credit x number of spreads) or $6,050 (Occurs beyond the outside strike prices)
Upper BE (Breakeven) = 163.95 (3rd strike + MG)
Lower BE (Breakeven) = 146.05 (2nd strike - MG)


Or, you can use Schwab StreetSmart Edge® to calculate as shown below.
Calculating maximum gain, maximum loss and breakeven for a short condor trade
Figure 2: Calculating maximum gain, maximum loss and breakeven for a short condor trade
Source: StreetSmart Edge®

The lines you'll want to show on the chart are the outside strike prices of 140 and 170 (represented by the red lines) and the upper and lower breakeven levels of 163.95 and 146.05 (represented by the green lines). Using the support and resistance line tool creates a chart as illustrated below:

Breakeven thresholds
Figure 3: Breakeven thresholds
Source: StreetSmart Edge®

The snapshot of the chart above was taken on January 12, 2015 with the February short iron condor having about 40 days until expiration. If ZYX is between 146.05 and 163.95 at the February option expiration, this trade will be profitable. The maximum gain will be reached if ZYX is anywhere between the second and third strike prices at expiration. This trade will be unprofitable if ZYX closes above 163.95 or below 146.05, with the maximum loss of $6,050 occurring at any price above 170 or below 140.

As you can see, short iron condor spreads allow for a fairly substantial move before they become unprofitable, whereas the maximum gain occurs over a wide range of prices; 150 through 160 in this example. In this example the profit zone occurs over a range of 17.90 points (163.95 – 146.05). ZYX has to move up more than 7.49 points (163.95 – 156.44), or down more than 10.39 points (156.44 – 146.05) to end up unprofitable.

Keep in mind

A short iron condor is often used as an alternative for a long condor, except that a short iron condor is initially established for a net credit while the long condor is initially established for a net debit. 

The risk and reward profiles, and profit and loss zones of the two strategies are very similar, so the decision of which to use often comes down to which might have a very slight pricing advantage, or whether you prefer to pay a debit (with no margin requirement) or receive a net credit (with a margin requirement equal to the maximum loss).

Conclusion

A short iron condor is a neutral strategy—appropriate when you expect the underlying security to remain in a narrow trading range over the life of the options. This four-legged strategy, created using both calls and puts, has four different strike prices and is established with the same contract quantity for each leg. A short iron condor has a limited loss potential if the underlying security moves more than expected.

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