Asked and Answered: How to Fly with Iron Condors

By TradeSmith Editorial Staff

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Traders and investors encounter three types of markets:

  1. Trending higher
  2. Trending lower
  3. Trending sideways
Naturally, you want to own stocks in markets trending higher and bet against them in markets trending lower.

But what do we do in sideways markets?

This is where options come in handy.

In a recent edition of TradeSmith Daily, I covered a handful of “neutral bias” options strategies. These strategies can help you profit from stocks and markets that move sideways.

However, I left one strategy out, and many of you emailed me to let me know.

Because let’s face it, iron condors are just plain cool.

Yet a lot of folks shy away from them because they seem complicated.

But once I break this strategy down, you’ll be well on your way to setting up and executing your own metal birds of prey.


Iron Condor Basics

Before we begin, I want to note that today’s discussion will center around iron condor credit spreads, not debit spreads.

In order to build an iron condor, we need to understand the mechanics behind an out-of-the-money options credit spread.

To create an out-of-the-money options credit spread, you take the following steps:

Call Credit Spread

  • Select a stock.
  • Sell a call option with a strike price above the stock’s current price.
  • Buy another call option with a strike price above the one you sold.
  • This pays you a credit when you initiate the trade.
  • Your maximum potential loss is the difference between the strike prices, minus the credit you received. This occurs when the stock finishes at or above the upper strike price by expiration.
  • Your maximum potential profit is the credit you receive. This occurs when the stock finishes at or below the lower strike price by expiration.

Put Credit Spread

  • Select a stock.
  • Sell a put option with a strike price below the stock’s current price.
  • Buy another put option with a strike price below the one you sold.
  • This pays you a credit when you initiate the trade.
  • Your maximum potential loss is the difference between the strike prices, minus the credit you received. This occurs when the stock finishes at or below the lower strike price by expiration.
  • Your maximum potential profit is the credit you receive. This occurs when the stock finishes at or above the upper strike price by expiration.
When you combine these trades, it creates an iron condor.

Let’s look at an example.

First, I find the perfect stock for an iron condor credit spread. The stock currently trades at $50.

So, I go ahead and do the following:

Call Credit Spread

  • Sell the $49 call strike expiring in two weeks for $3.00.
  • Buy the $51 call strike expiring in two weeks for $2.50.
  • I receive a net credit of $0.50, which is my maximum potential profit.
  • My maximum potential loss is $51.00 – $49.00 – $0.50 = $1.50, which occurs when the stock is at or above $51 at expiration.

Put Credit Spread

  • Sell the $46 put strike expiring in two weeks for $3.00.
  • Buy the $44 put strike expiring in two weeks for $2.50.
  • I receive a net credit of $0.50, which is my maximum potential profit.
  • My maximum potential loss is $46.00 – $44.00 – $0.50 = $1.50, which occurs when the stock is at or below $44 at expiration.
Here’s what the payoff graphs look like for a call and put credit:



Source: TradeSmith

The blue line in each graph represents the profit or loss at any given stock price at expiration for the put credit spread or the call credit spread.

If you combined these two trades into one, your payoff diagram would look something like this:


Source: TradeSmith

I want you to notice several key differences here.

First, the maximum loss is now $1 and can occur when the stock finishes at or below $44 or at or above $51.

The maximum profit is now $1.

Why is this?

If the stock fails on the put credit side, that means the call credit side has to turn a profit, and vice versa. You cannot lose on both sides at the same time.

Plus, you get a credit from selling a put and call spread, which is why your maximum potential profit jumps to $1.

This sounds great, right?

The trade-off is that you need the stock to sit between the strikes in order to turn a profit.

If you sold only a put credit spread, the stock could move nowhere or higher and you would turn a profit.

If you sold only a call credit spread, the stock could move nowhere or lower and you would turn a profit.

With an iron condor credit spread, you need the stock to stay put.


Tips of the Trade

While you can set up an iron condor credit spread all at once, you don’t have to.

Let’s say you want to set up a trade on IBM Common Stock (IBM).


Source: TradeSmith

The daily chart above displays the trading range for the last three months.

I added orange trend lines that bracket the higher and lower portions of the trading range.

A trader could take advantage of the typical trading range by selling an out-of-the-money put credit spread near the bottom trendline and an out-of-the-money call credit spread near the upper trendline.

That would allow the trader to either receive a larger credit or go out further with their strike selection for the same credit as if they initiated the entire trade in the middle of the range.

But be careful. You don’t want to get caught in a position where you intended to set up an iron condor credit spread and only set up the call or put credit spread without the other. So be sure that if you want to put on each side of the trade separately, you have a structured plan to do so.

Lastly, like any other credit spread, iron condor credit spreads need option liquidity (volume). So make sure you stick with heavily traded stocks that have at least weekly option expirations.

Looking across the market, what sector or segment do you think offers the best setup for an iron condor credit spread?

Email me your picks and let me know why.

While I can’t answer your emails individually, I promise to read every one.