A short iron condor is a market-neutral strategy that combines two credit spreads. A call credit spread is implemented above the current stock price, and a put credit spread is implemented below. The objective of any credit spread is to profit from the short options’ time decay while protecting the position with further out-of-the-money long options.

It’s a Theta Trade

The option greek that makes the biggest impact on a short iron condor is theta. The iron condor is simply combining both the call and put credit spreads into one trade. The trade has two forms of positive theta courtesy of two typically out-of-the-money (OTM) credit spreads. The trade is based on the possibility of the stock trading between both credit spreads by expiration. A delta neutral position is favorable for a short iron condor. That means essentially the underlying is staying about even between the short strikes. If delta grows either in a positive or negative manner, the underlying is moving toward or through one of the short strikes and positive theta starts to decrease.

Iron Condor Example

Let’s use XYZ stock as an example. If the stock has been trading between a range of $75 and $80 over the past few weeks, a short iron condor might be an option with an expiration from about a week to a month. A call credit spread with the short strike call at 80 or higher would profit if the stock stayed below $80 at expiration. A short strike put at 75 or lower would profit if the stock stayed at $75 or higher at expiration.

Both short options would need to be protected by further out-of-the-money (OTM) long options. Both spreads would expire worthless and both premiums would be the trader’s to keep if XYZ closes at or between the short strikes. The total risk on the trade is also reduced because of both premiums received.

Max profit is both credits from each credit spread. Max risk is the difference in one set of strike prices minus both premiums received. Maximum loss would occur if the stock is at or below $75 or at or above $80 at expiration. No matter what happens, one of the credit spreads will always expire worthless. This, of course, does not guarantee a profit.

Manage Your Risk

Iron condors are a great way to take advantage of time decay (positive theta) when it looks as if the stock will be traveling in a range for a certain amount of time. As any smart risk manager knows, the key is to have your profit and loss parameters set before entering the trade and stick to them.

John Kmiecik, Market Taker Mentoring