An Iron Condor trade consists of selling an out-of-the-money (OTM) put and buying a deeper OTM put for protection, then at the same time selling an OTM call and buying a deeper OTM call for protection. The investor receives a net credit for the four-legged transaction as the short (sold) options have a higher premium than the long stock options. In simpler terms, it is a combination of a Bull Put Credit Spread and a Bear Call Credit Spread.
Let’s look at an example:
- XYZ is trading at $110.
- Sell 120 Call for $1.25.
- Sell 100 Put for $0.75.
- Buy 125 Call for $0.65.
- Buy 95 Put for $0.20.
- Total Net Credit = $1.15 (2.00 – $0.85).
As long as XYZ stays between $120 and $100, all four stock options will expire worthless and the investor will keep the net credit. By purchasing the outside stock options the potential risk is limited. If the stock goes to $130 for example, the investor is obligated to deliver shares of stock at $120, but has reserved the right to buy shares of stock at $125. The maximum loss on the position is $3.85 (5 point max loss – the net credit). This means that the margin requirement for the Iron Condor trade (for 10 contracts) would be:
- $3.85 * 10 * 100 = $3,850.
- The maximum % return would be: $1,150/$3,850 = 29%.
In comparison, the Short Strangle consists of selling an OTM put and an OTM call just like the Iron Condor, however, the investor does not purchase the deeper OTM put and the deeper OTM call.
The similar Short Strangle trade would be:
- Stock XYZ is trading at $110.
- Sell 120 Call for $1.25.
- Sell 100 put for $0.75.
- Total Net Credit = $2.00
Because the investor does not purchase the outside options, the Total Net Credit is $0.85 higher. Also, this is only a two-legged strategy so the investor will save on commissions cost.
So why would an investor ever trade the Iron Condor over the Short Strangle?
The reason is simple: The margin that is required for the Short Strangle is much higher than the requirement for the Iron Condor. Although brokerage houses differ in their requirements, the standard requirement for the Short Strangle trade is the call strike price + the put premium * # of contracts * 100. In our example (for 10 contracts)…
- Margin requirement would be: (120 + $0.75) * 10 * 100 = $120,750.
- The maximum % return would be: $2,000/$120,750 = 1.6% return.
The purchase of the outside wings in the Iron Condor trade limits the margin requirement for the trade. In the above examples an investor would look to make $1,150 against a $3,850 investment with the Iron Condor trade. With the Short Strangle the investor has no outside protection and is exposed with two naked options. In the similar Short Strangle trade the investor could make $2,000 but it is against a $120,750 investment. This is why it is generally better to trade an Iron Condor instead of a Short Strangle.
Here’s another thought: With $120,000 set aside an investor could place a 10 contract Short Strangle trade as outlined above, however, they could diversify their personal stock portfolio and place three 10 contract Iron Condor trades. This limits the overall exposure if the first selected trade were to go against the investor.
The margin requirements listed above are based only on the standard of some options brokerage houses. Many online options brokers will only require you to cover one side of the Iron Condor spread (as shown in the example). The theory being that if the stock or index goes against the investor in one direction, the other side of the spread will be further OTM and at less risk. However, some brokerage houses still might require the investor to cover the margin on both sides of the Iron Condor spread.
If you use a broker who has lower requirements for the Short Strangle or Iron Condor trades, let us know!