The arrival of the financial markets in the UK has seen an efflorescence of options trading activity. Many different strategies can be employed when engaging this type of market; however, one popular option has been to use iron condors.
What is an Iron Condor?
An iron condor is a combination strategy that consists of purchasing a put and selling another put at a higher strike price (to form the upper side of the ‘iron’). A call is also purchased, and another call is sold at a lower strike price (forming the lower part of the ‘iron’). The two call contracts are usually out-of-the-money and serve as insurance against volatility expansion: they limit losses if share prices increase sharply.
Typically, traders will try and sell an option with a strike price close to the underlying asset’s current market price (strike ‘B’). The premium paid for this contract will be lower than an out-of-the-money option, and it will limit losses if volatility declines.
Using a Super Iron Condor
On the other hand, traders will buy insurance against high levels of share price volatility; therefore, they sell an option at a higher strike (strike ‘C’) and receive more premium as compensation. This is termed a ‘super-iron condor’ and tends to be less popular because there is less room for manoeuvre should prices rise or fall abruptly; however, even more significant risk/reward ratios can be achieved as a result. The combination of buying one put and selling another above creates a net credit on the position, while buying another put and selling another call below results in a net debit.
For this strategy to succeed, the share price must not move outside the defined range between strikes A and C (the ‘iron’). If prices fluctuate beyond this level, then losses can mount quickly: gains on one leg will be offset by losses on the other, and traders may find themselves losing money overall, despite having initiated a position with a positive initial cash flow.
Using a Bull Iron Condor
Combining two strategies is called a ‘bull-iron condor’ because it has limited risk if share price movements are confined within a specific range during the expiry period. This position can benefit from significant returns on investment, even if volatility remains subdued or implicit premiums remain low due to lacklustre interest rates.
It also allows traders to better take advantage of other opportunities that arise between trade entry and exit; for example, they can be used as an initial hedge against losses through other types of trades (such as straddles). The main point is that this type of strategy offers more flexibility than debit spreads which are almost entirely dependent on implied volatility changes for their profitability.
Risks and benefits of using Iron Condors
Most experienced options traders try to avoid iron condor positions because it is challenging to manage such transactions without incurring significant losses if volatility moves against them; they also prefer trading strategies that give them greater flexibility when managing their positions.
However, experienced traders do not eschew the iron condor entirely because it can be used successfully in certain market conditions. For example, during times of low volatility, when there is little chance that the share price will react violently to new information or macroeconomic events, this strategy can yield high returns even if gains are comparatively modest as a result.
Iron condors can be used as a hedging mechanism to cover potential losses through other strategies, such as straddles. This is because of the greater range of movements within which share price volatility stays; this allows for more flexibility when managing exposure to those other trades or even reaching expiry without incurring a significant financial loss. New investors are advised to use a reputable online broker from Saxo markets and trade on a demo account before investing real money.