Credit/Credit Spread Strategy:
Iron Condor

ANALOGY/METAPHOR: Being an Insurance Company in Both Directions - Insuring Shareholders Against Defined Drops AND Rises in a Stock's Share Price

ACTION: The iron condor consists of constructing both a bull put spread and a bear call spread on the same underlying stock with the same expiration date. Specifically, you write an out of the money (OTM) put option and purchase a farther out of the money (FOTM) put option (to form a bull put) as well as write an OTM call option and purchase a FOTM call option (to form a bear call), all for a net credit. The maximum gain is the total amount of net credit received if the share prices finishes between the higher strike price put and the lower strike price call.

DESCRIPTION: You are essentially acting as an insurance company that really enjoys writing insurance policies. In this case, you're insuring a specific stock in another investor's portfolio from both increases AND decreases in share price. You're literally setting up both a bull put spread and a bear call spread on the same underlying stock with the same expiration date. In effect, you're insuring against moves outside a pre-determined trading range.

As with bull put spreads and bear call spreads, there are three variables involved in this trade: what prices (low and high) you're insuring the stock at (strike prices); how long the coverage period is (expiration date); and how much income you collect (net premium from both legs).

[note: If you're unfamiliar with bull put and bear call spreads, please review those option trading strategies first. The iron condor is very easy to comprehend once you've got the other strategies down.]

EXAMPLE: The XYZ Zipper Company is trading at $30/share. Earnings season is still two months away and the company hasn't produced a controversy in quite some time. You feel confident that the stock won't stray very far from its current price in the near term. You consult the option chains and decide to employ the iron condor option trading strategy, setting up both a bull put spread and a bear call spread on the stock.

For simplicity's sake, let's assume that you set up both the bull put and bear call portions of the trade at the same time (although that isn't required), and all expiration dates are 30 days away. You sell a $27.50 put option for $1/contract and purchase a $25 put option for $0.50/contract (netting you a $0.50 credit). You then sell a $32.50 call option for $1/contract and purchase a $35 call option for $0.50/contract (netting you another $0.50 credit). Excluding commissions, you receive a net credit of $1/contract, or $100 ($2 in total credits less $1 in total debits).

The table below illustrates the possible scenarios depending upon the stock's final share price.

One other item to note: The bull put and the bear call portions of the trade are not required to be set up at the same time. In fact, many traders who employ the iron condor set up one leg initially and then only later, if they feel it's advantageous, will they add the second leg.

VARIATIONS: n/a

OTHER: The interesting question is which is more risky and which is more rewarding--iron condors or individual bull put and bear call spreads?

The Case for the Iron Condor (vs. a Bull Put/Bear Call Spread)

• Potential to double the premium you would otherwise receive for having set up the single leg spread.

• Potential to receive the same premium you would otherwise receive for having set up the single leg spread (either a bull put OR a bear call) but take less risk by setting the strike prices farther out of the money.

• There's a 100% chance that one side of your iron condor will expire worthless and you'll be able to keep the full amount of the premium received for that spread.

• No additional margin/capital is theoretically required to add a second leg and upgrade a single spread into an iron condor. Since a stock can't close both below your put option strike prices and above your call option strike prices, most options-friendly brokers won't require any additional capital to collateralize the trade. If the difference between strike prices for both the bull put and bear call is $2.50, then no matter what happens, the most you can still lose is $250 (less premium received), not $500. [note: not every brokerage sees it this way, however; some will still require you to collateralize with $500.]

The Case against the Iron Condor (vs. a Bull Put/Bear Call Spread)

• There's only one real drawback, but it's significant. By betting against specific moves both to the upside AND the downside, you double the ways in which you can lose money. If it's true that one leg is guaranteed to expire worthless, it's also true that there's an increased chance that the other side will be threatened or even breached at some point during your holding period.