Introduction:
Although options trading allows you to participate in the derivatives market and earn handsome returns, it entails high risk. Thankfully, there are several options trading strategies that you can deploy to ensure minimum loss and maximum profit. One such strategy is the iron condor strategy.
The iron condor options trading strategy allows you to exploit the low-volatility sideways market. That is why it is also known as the limited-risk strategy.
Continue reading to learn about the iron condor strategy, the associated risks and rewards, and how it works.
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What is the iron condor strategy?
The iron condor is an options trading strategy with defined risk and a directionally neutral approach towards the market. It aims to generate profits when the underlying securities remain range-bound as the option contract’s expiry approaches.
This strategy involves buying two call options (one extended and one short) and two put options (one long and one short), all with the same expiry date. When the price of the underlying securities remains within these strike prices at the time of the options’ expiry, you make a profit.
The iron condor works on the principle of a standard condor spread by using both call and put options instead of just call or put options. Hence, this strategy helps you during a neutral market when neither call nor put can earn profits due to the impact of the theta decay.
How to create an iron condor?
As mentioned, the iron condor strategy involves using four call-and-pull options with the same expiry date. Here’s what you need to do to construct an iron condor:
Step 1 – Sell an out-of-the-money put option
Step 2 – Buy a long put option that is further out-of-the-money
Step 3 – Sell an out-of-the-money call option
Step 4 – Buy a long call option that is further out-of-the-money
As you can see, the iron condor strategy is very similar to the iron butterfly strategy as it involves four options with the same expiry date. This four-legged options trading strategy involves a bull call spread and a bear put spread.
How does the iron condor strategy work?
When you create an iron condor, the wings protect against big swings in either direction. Thus, the risks of erratic upside or downside are minimised. The profit potential is also limited due to the restricted risk.
This technique works well when the market is range-bound, and all four options expire worthless. You will make a maximum profit if the price of the underlying shares remains between the strike prices of the middle two call-and-get options. Even if you suffer a loss, it would be the minimum.
The iron condor strategy: An illustration
Now, let’s understand how the iron condor strategy works with the help of an illustration. Suppose the shares of a company ABC are trading for Rs. 150 in August. You have a neutral perspective on the shares and, hence, decide to create an iron condor.
- You buy one Put Option with September expiry and a strike price of Rs. 130 at a premium of Rs. 20
- You buy one Call Option with September expiry and a strike price of Rs. 170 at a premium of Rs. 20
- You sell one Put Option with September expiry and a strike price of Rs. 140 at a premium of Rs. 40
- You sell one Call Option with September expiry and a strike price of Rs. 160 at a premium of Rs. 40
Imagining each option to have a lot size of 1000 shares, your initial overall gain at the outset is Rs. [{(40 x 1000 + 40 x 1000)} – {(20 x 1000) + (20 x 1000)}], i.e., Rs. 40,000.
Now, if the market moves sideways and the price of the ABC shares remains between Rs. 140 to Rs. 160 per share at expiry, all four options will expire worthless as none of the buyers would want to exercise their right to buy/sell shares. And in such a case, you can keep the profit of Rs. 40,000.
However, if the share price closes below Rs. 140 or above Rs. 160, you will incur a loss since either the buyer of the put or call option will exercise his right. However, your net loss would be limited.
In conclusion
The iron condor strategy best suits options traders during less volatile markets. If you’re using this strategy as a beginner, ensure you get the basics right and know the maximum loss you can incur. If you need a Demat account for investing, you can get it for free with Motilal Oswal.
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