Iron condors

In short

A friend of mine once said that the best trades are the ones that bore you. An iron condor is built for that kind of boredom. It is a way of selling two option spreads at once, one below the market and one above it, and collecting a payment up front. The trader keeps that payment if the stock stays inside a range until the options expire. The most the trader can lose is fixed on the day the trade is opened, and it is the width of one spread minus the payment received, times 100 shares. Before placing one, a trader should read the options disclosure document that every broker provides, called Characteristics and Risks of Standardized Options. Check your broker's approval level too, since the firm sets who may place spreads.

The whole of it

What it is

I once watched a neighbor fence in his garden with two sets of posts, one on the north side and one on the south. He did not care much which way the rabbits came from. He only cared that they stayed out. An iron condor works a little like that fence. It is four option contracts on the same stock or index, all with the same expiration date, bought and sold together as a package.

An option is a contract that gives its owner the right, but not the duty, to buy or sell 100 shares at a set price by a set date. A call is a right to buy. A put is a right to sell. The set price is called the strike.

The package has two halves. The first half is a put credit spread. The trader sells a put at a lower strike, then buys another put at a still lower strike to cap the risk. The second half is a call credit spread. The trader sells a call at a higher strike, then buys another call at a still higher strike for the same reason. The trader receives cash when the package is sold. That cash is called the credit.

So the trader is paid to say the stock will stay between the two short strikes. The price at which the trader hopes to stay put is a range, and the trade makes money inside it.

How it works

If you have ever watched a stock sit quietly for a month, you have seen the picture a condor trader hopes for. Time helps the seller of an option. As the days pass, the options lose value if nothing happens, and the trader can buy the package back for less or let it expire.

Here is the shape of it. If the stock closes at expiration between the two short strikes, all four options expire worthless, and the trader keeps the full credit. That is the best case. It is also the most the trade can ever earn.

If the stock falls below the short put strike, the put spread starts to lose. If the stock rises above the short call strike, the call spread starts to lose. The long options act as a stop. Once the stock moves past the long strike on either side, the loss stops growing. That loss is the worst case.

Only one side can lose at expiration. The stock cannot finish both far above and far below at once. That is why the maximum loss is the width of one spread, not both, minus the credit. The two break even points sit outside the short strikes. The lower one is the short put strike minus the credit per share. The upper one is the short call strike plus the credit per share.

Early assignment is a risk worth knowing. The buyer of an American style option may exercise it before expiration. The seller then has to deliver shares or cash. Index options that settle in cash and are European style avoid most of this, but each product has its own rules, so the trader should read the contract terms.

The numbers, and where to find yours

Costs matter here, and so do the rules. Four contracts means four commissions if the broker charges them, and opening and closing doubles that. The trader should look at the broker's fee schedule for the per contract fee. The bid and ask prices matter too. A trader who sells the package at the bid and buys it back at the ask gives up a little each time.

Margin, meaning the cash the broker holds as collateral, is set by the broker within the rules of FINRA and the exchanges. For a defined risk spread, the broker generally holds back the maximum loss. The trader should check the broker's margin page for the exact figure.

Option approval levels are set by each broker. Spreads often need a higher level than simple option buying. The trader should look at the account application and the broker's options page.

Taxes depend on the product. Some index options get special treatment under Section 1256 of the Internal Revenue Code, which has its own rules for how gains are split between short term and long term. Whether a given option qualifies is a question for IRS Publication 550 and a tax professional. If a limit or rate applies, it is the current figure, which the official source publishes each year.

For the contract details, the Options Clearing Corporation publishes the terms of listed options. For the risks, the disclosure document named in the first section is the official starting point. For the numbers on any single trade, the broker's option chain shows the bid, the ask, and the strikes.

A worked example

A friend of mine named Daniel watched a fund that tracks a broad index trade near $100 a share. He thought it would drift sideways for a month. He opened an iron condor with four contracts, all expiring on the same date.

He sold a put at the $95 strike and bought a put at the $90 strike. He sold a call at the $105 strike and bought a call at the $110 strike. He received $1.00 a share for the whole package. Each contract covers 100 shares, so his credit was $1.00 times 100, which is $100.

His maximum gain was that $100, less any commissions.

His maximum loss needs one more step. Each spread is $5 wide, since $95 minus $90 is $5. A $5 spread is worth $5 times 100, which is $500 if it ends fully against him. He already collected $100. So his worst case is $500 minus $100, which is $400.

His break even points follow from the credit of $1.00 a share. The lower one is $95 minus $1.00, which is $94. The upper one is $105 plus $1.00, which is $106. Between $94 and $106 at expiration, he does not lose money on the trade. Between $95 and $105, he keeps the full $100.

Now suppose the fund closed at $102. Every option expired worthless. Daniel kept the $100. Suppose instead it closed at $92. The $95 put was worth $3 a share against him, and the $90 put expired worthless. His loss on the spread was $3 times 100, which is $300, and he had taken in $100. His net result was a loss of $200.

Same trade, two results. Neither was a surprise, because the numbers were fixed from the start.

Where it goes wrong

I have noticed that people judge a trade by its win rate and forget the size of the loss. That is the trap. A condor often has a good chance of a small gain and a smaller chance of a larger loss. In Daniel's case, the $100 he could win sat against the $400 he could lose. A few small wins can be erased by one bad month.

Big moves hurt. A surprise earnings report, a sharp market drop, or a sudden news event can push the stock past a long strike fast. The loss then lands at its maximum.

Costs can quietly eat the gain. If four contracts cost $2.60 to open and $2.60 to close, that is $5.20 against a $100 credit, before the spread between bid and ask is counted.

Early assignment can surprise a seller, especially near a dividend date or when an option is deep in the money. The broker may then post shares or cash to the account, and that can strain a small balance.

Closing one side early can leave the other side exposed to a new risk. Many traders close the whole package at once for that reason, but each trader should confirm the plan before the trade, not during it.

Questions to answer before you leave this page

Do you know the maximum loss on the trade you have in mind, in dollars, after the credit is counted? Have you read Characteristics and Risks of Standardized Options, and does your broker approve you for spreads? Can you afford to lose that full amount without it changing your month? What do the commissions and the bid and ask gap cost you on all four contracts, in and out? Which expiration date and which strikes are you looking at, and do you know where your break even points fall? Is the product American style or European style, and what does that mean for early assignment? And if the stock gaps past a long strike overnight, would you still be comfortable with the loss you agreed to when you opened the trade?