A reverse iron condor consists of buying an out-of-the-money bull call debit spread above the stock price and an out-of-the-money bear put debit spread below the stock price with the same expiration date.
Reverse iron condors are essentially a long strangle with short options sold out-of-the-money that reduce the position’s cost basis but limit profit potential.
Reverse iron condors are market neutral and have no directional bias but require a large enough move in the underlying asset to exceed the break-even price. A debit is paid when the position is opened and the risk is limited to the amount paid. Reverse iron condors need a significant price change and/or increased volatility before expiration to collect higher premiums when the trade is exited. A sharp rise in implied volatility typically accompanies large moves in stock prices.
An investor would look to initiate a reverse iron condor when the belief is the stock price will make a large move in either direction before expiration and implied volatility will increase.
Reverse iron condors are similar to long strangles in objective: they depend on large directional moves and increased volatility. However, reverse iron condors are less expensive than a long strangle because short options are sold above the long call and below the long put. This lowers the total amount paid to enter the trade but will limit the profit potential to the width of the spread minus the initial debit paid.
Reverse iron condors can be purchased any distance from the stock price and with any size spread between the long and short options. The closer the strike prices are to the underlying’s price, the more debit will be paid, but the probability is higher that the option will finish in-the-money. The larger the spread is between the long option and the short option, the greater the maximum profit potential, and the more the strategy will resemble a long strangle. However, less credit will be collected on the short positions to offset the cost of the long positions and the maximum loss will increase.
The payoff diagram is well defined with a reverse iron condor. The maximum loss on the trade is defined at entry by the combined cost of the spread positions. The profit potential is also defined at entry. The width of the spreads minus the combined cost of the spreads is the maximum amount that can be gained.
For example, if a stock is trading at $100, a bull call spread may be purchased with a long call option at $105 and a short call option at $110. A bear put spread may be purchased with a long put option at $95 and a short put option at $90. If the cost to enter the trade is $2.00, the max loss is -$200 if the stock closes between $95 and $105 at expiration. The max profit is $300 if the stock closes above $110 or below $90 at expiration. The break-even points would be $107 and $93.
Reverse iron condors are created by buying a debit spread above and below the current stock price. This requires buying an out-of-the-money option and selling a further out-of-the-money option. For example, if a stock is trading at $100, a bull call spread could be entered by purchasing a $105 call and selling a $110 call. A bear put spread could be entered by purchasing a $95 put and selling a $90 put. This would create a $10 wide reverse iron condor with $5 wide wings. If the debit paid to enter the trade is $2.00, the max loss would be -$200 and the max profit would be $300.
The spreads can be any width and any distance from the current stock price. The closer the strike prices are to the underlying’s price, the more debit will be paid, but the probability is higher that the option will finish in-the-money. The larger the width of the spread is between the long option and the short option, the less premium will be paid, but the risk will be higher.
A reverse iron condor looks to capitalize on a sharp move in stock price, implied volatility, or both. If the underlying asset moves far enough before expiration and/or implied volatility expands, the trade is exited by selling-to-close (STC) one or both of the two long spreads. The difference between the cost of buying the premiums and selling the premiums is the net profit or loss on the trade.
Typically, reverse iron condors are exited before expiration because an investor will want to sell the options before the extrinsic value disappears. However, if the stock price is above or below the short option at expiration, the maximum profit will be realized.
Time decay, or Theta, works against the reverse iron condor strategy. Every day the time value of the long option contracts decreases. Ideally, a large move in the underlying stock price occurs quickly, and an investor can capitalize on the remaining extrinsic time value by selling the option.
Reverse iron condors benefit from an increase in the value of implied volatility. Higher implied volatility results in higher option premium prices. Ideally, when a reverse iron condor is initiated, implied volatility is lower than where it will be at exit or expiration. Future volatility, or Vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the reverse iron condor strategy’s pricing.
Reverse iron condors have a finite amount of time to be profitable and have multiple factors working against their success. If the underlying stock does not move far enough, fast enough, and/or volatility decreases, the reverse iron condor will lose value rapidly and result in a loss. Reverse iron condors can be adjusted like most options strategies but will almost always come at more cost and therefore add risk to the trade and extend the break-even points.
If the underlying stock has not moved into a profitable zone by expiration, the options can be sold, and a new reverse iron condor position can be purchased for a later expiration. This can also be done before expiration if an investor wishes to recapture some of the premium before the contracts expire worthless. Keep in mind that this will require the stock to make an even larger move than the original trade and add risk by increasing the amount of capital committed to the trade.
Reverse iron condors can be rolled up or down, or out to a later expiration date if the stock price or implied volatility has not moved enough to realize a profit. To roll out the reverse iron condor, close the current position and initiate a new position for a later expiration. The new reverse iron condor may be at the same strike prices or adjusted up or down to reflect any stock price changes. If the underlying stock has not moved, one or both options may be adjusted closer to the stock’s current price.
For example, on a position that has exhibited low volatility, if a bull call spread was purchased at $105/$110 and a bear put spread purchased at $95/$90 on a $100 stock, and the stock is still at $100, the call spread could be moved down to $102/$107 and the put spread could be moved up to $98/$93. The downside to rolling out long options is the roll will most likely cost money and therefore increase the risk of the original trade. The risk is still defined, but the additional debit will not only create a higher potential maximum loss, but also require the underlying stock to move more to exceed the break-even point.
Hedging a reverse iron condor may be a proactive way to help retain some profits if the stock has moved sharply early in the expiration period while minimizing the overall risk of the position. Reverse iron condors need a sustained move in one direction to realize a profit. However, stocks can move quickly and retrace, leaving a once profitable position worthless.
If the underlying stock moves up or down toward one of the debit spreads, an investor may choose to hedge against a future move back in the opposite direction of the initial move. If the underlying asset moves up, an investor may choose to sell a bear call credit spread above the bull call spread. Conversely, if the underlying asset moves down, a bull put credit spread could be sold below the bear put spread. If the underlying stock were to retrace from its initial move, the credit spreads would expire worthless and the credit received would help offset the unrealized profits of the debit spread.
A reverse iron condor is a neutral options strategy with defined risk and limited profit potential. The strategy looks to take advantage of rising volatility and a large move from the underlying asset.
Reverse iron condors typically have a lower profit potential and lower risk. Reverse iron condors are generally bought out-of-the-money.
Reverse iron condors are debit strategies that require a large move from the underlying stock to be successful. Iron condors are credit strategies that benefit with the underlying stock stays within a range and volatility does not increase. Both strategies have defined risk and limited profit potential.