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December 18, 2012

Iron Condors 101

There are a few things that anyone looking to trade Iron Condors need to know first:
  1. Iron Condor is a Volatility bearish trade
  2. Limited Risk/Limited Reward
  3. Low reward/high probability
  4. Goal is to let sold options expire worthless as you are selling time premium
What makes an Iron Condor is a combinations of a Bear Call Spread and a Bull Put Spread. Let's say XYZ is trading at 50 in May. To put on a Bear Call spread you would sell June 55 call and buy June 60 call. To put on a Bull Put spread you would sell a June 45 put and buy June 40 put. The reason for buying the wings (60 call and 40 put) is to limit downside. Speaking of downside, what is your total risk on this trade?
  • Max Loss = Strike Price of Long Option - Strike Price of Short Option - Net Premium Received
So, if you sold a Bear Call Spread for .40¢ your max loss is : 60-55-.40=4.60
Remember, each contract represents 100 shares of XYZ. Therefore your max loss on this trade would be $460. Same goes for the Bull Put Spread. 

Your breakeven points are:
  • Upside Breakeven Point = Strike Price of Short Call + Net Premium Received
  • Downside Breakeven Point = Strike Price of Short Put - Net Premium Received
One question people ask, why would anyone risk $460 to make $40?
And the answer is simple 40/460=8.69% return on risk. If you're collecting .40¢ for selling a Bear Call Spread and say you sell a Bull Put Spread for .60¢ (remember, Iron Condor is a cominations of bear calls and bull puts) now you have a total credit of $1. Now your looking to make $1 risking $4. That's 25% reward on risk. Since options expire every 3rd friday of each month, most would considered 25% return pretty good.