What Your Mother Didn’t Tell You About Trading Iron Condors

Iron condors are an excellent strategy for options traders of all experience levels. But there are some key factors that all traders should understand before they begin trading because sometimes trades don’t always go as planned.

What is an iron condor?

An iron condor is a multi-leg, risk-defined, neutral strategy with limited profit potential. Iron condors look to take advantage of decreasing volatility, time decay, and rangebound price action.

An iron condor is simply an out-of-the-money bear call credit spread sold above the stock price, and an out-of-the-money bull put credit spread sold below the stock price. All four legs of the position have the same expiration date. 

The max profit and loss potential is always known when opening an iron condor. If the price closes between the two short strike prices at expiration, the credit you received is realized as a profit. 

You will realize the maximum loss if the underlying price is above or below one of the long strikes at expiration. You can calculate break-even points by adding or subtracting the total credit received, above or below the short options. 

For example, if you enter an iron condor for a $2.00 credit, the break-even price will be $2.00 above the short call strike and $2.00 below the short put strike.

In this payoff diagram, the $5 wide call spread is sold at $105, and the $5 wide put spread is sold at $95. Therefore, the break-even prices are $107 and $93.

The position is profitable if the stock is between the break-even points at expiration. The max profit occurs between the short strikes ($105 and $95). Above $110 or below $90, the position is a full loss (but I’ll teach you how to adjust the position soon).

Here’s an easy way to calculate an iron condor’s profit.

Of course, you can always exit the position before expiration. If the stock hasn’t moved very much, you can likely buy the position for a profit.

Pretty easy, right? Almost. There are a few more things you should know.

Choosing the right strike prices

You can sell an iron condor any distance from the stock’s current price and with any size spread between the short and long options. Here is what you need to consider when entering the position.

The closer the strike prices are to the underlying’s price, the more credit you’ll receive. However, there is a higher probability the option will finish in-the-money.

Don’t worry; you can always use delta to determine probabilities.

Similarly, when comparing options with the same strike price, longer-dated contracts are more expensive because there’s more time for the underlying stock to move above or below the strike prices.

I believe it is best to enter iron condors 30 to 40 days from expiration to capitalize on the rapid time decay of options while allowing you enough time to collect decent premiums from the remaining extrinsic value. 

It also gives you time to adjust positions before expiration. Anything within 30 days makes it difficult to adjust if the trade goes against you.

Finally, the wider the spread width between the short and long options, the more premium you’ll collect, but the maximum risk will be higher.

For example, a $5 wide spread that collects $1.00 of premium has $400 of risk. A $10 wide spread that collects $3.00 of premium has $700 of risk. More reward, more risk. (Isn’t it always that way?)

Standard deviation and normal distribution are tools you can use to set up your position with a high probability of success. 

For example, in a normal distribution, one standard deviation accounts for 68% of the data measured, and two standard deviations represent 95% of expected outcomes.

This means you can set up your iron condor one standard deviation above and below a stock’s price (approximately the 0.15 delta) to create a roughly 68% probability of success.

For example, in the image below, there is a 68% probability the stock price will be inside the defined range on the contract’s expiration date. Notice I said at expiration, not before.

Rule #1: Managing your risk

As we mentioned earlier, you know the best-case and worst-case scenarios when you enter the trade. But how do you manage your risk correctly?

Position sizing. Position sizing. Position sizing. (Did I mention position sizing?) Because iron condors are risk-defined, you can control your exposure with the number of contracts traded. 

Remember, your max loss is the credit received minus the spread’s width.

In the example above, collecting $2.00 on the $5 wide iron condor means the most you can lose is $300 per contract. ($2 - $5 = -$3 (x100 per contract)). Trading three contracts? Your max risk is $900. 

You can use position sizing to calculate how many contracts you should trade. Better yet, let the bots do it for you!

Watch this video to learn more about calculating an iron condor’s risk.

Adjustments: What to do when the trade goes wrong

Now, it’s time to talk about what happens when the position goes against you. If you trade iron condors, you’ll have a challenged position at some point. But it’s nothing to be afraid of. You can easily adjust an iron condor to reduce risk.

When the stock price goes above or below the call or put’s strike price, the position is considered ‘challenged’ because it is outside the profitability zone.

I use my own set of adjustment rules and follow them in times of market volatility.

Adjusting an iron condor typically brings in more credit, which increases the maximum profit potential, decreases the maximum risk, and widens the break-even points. 

However, the position's range of profitability decreases as the iron condor's width tightens.

Here’s a look at adjusting the iron condor I discussed earlier. In this example, I adjusted the position up as the stock price increased above the short call strike.

Notice the max risk decreased as I brought in more net credit. However, the position's break-even prices are now $97-$108, as opposed to $93-$107.

I suggest going here to learn more about adjusting and rolling iron condors (there are more examples, too!).

You can also roll a challenged iron condor to a future expiration date to maximize the trade’s potential profit. All you have to do is purchase the original position and reopen it with the same strike prices but for a future expiration date. I will only do this if it results in a credit because it will widen the break-even points.

Pro tip: I never like to pay for adjustments because it increases the position’s risk.

Check out what it looks like to roll the same position out for a $1.00 credit.

Summary & Automation

Iron condors are a great strategy for new and experienced traders alike. Their benefits include defined risk, low capital requirements, and the ability to enter high probability trades. Iron condors are effective when the market is trading in a tight range with decreasing volatility. 

Now that you have a thorough understanding of iron condors (and what to do if they move against you), consider automating the strategy. In this workshop, I show you how to create a very simple iron condor trading bot.