The iron condor is an options trading strategy that can be used to profit in a market with little volatility

• An iron condor is a options trading strategy that minimizes risk while profiting from low volatility.
• This strategy is constructed of two calls and two puts with different strikes but the same expiration.
• You can profit from an iron condor whether the underlying stock or index rises or falls.

Trading stock options, long the territory of professional investors, has become much more popular among individuals. You might be familiar with the basic concept. Instead of buying the stocks, you use options to bet on the future direction and magnitude of the move in the price of the stocks. If you predict correctly, you profit from the trade. If not, you lose.

There are many advanced options trading strategies you can use based on how volatile you think a particular stock or index will be and whether it will rise or fall. Others, including one known as the iron condor, are non-directional, or market neutral. That means you can profit from them no matter which direction the underlying stock or index moves.

Read on to learn how iron condors work, when trading them can be profitable while limiting risk, when to use them, and why they are called iron condors in the first place.

What is an iron condor?

"The iron condor strategy gets its name from its depiction on a profit/loss diagram," says Robert R. Johnson, a professor at the Heider College of Business, Creighton University. "The graph looks like a bird with its head rising and wings outstretched."

An iron condor trade consists of two puts (one long and one short) and two calls (one long and one short), each with different strike prices but the same expiration dates. In the illustration above, the short put and the short call make up the body of the bird. The long put and long call make up the wings.

"The use of the word 'iron' comes from the fact this trade employs both calls and puts," notes Don Kaufman, co-founder and chief market strategist at the trading education firm TheoTrade.

The biggest advantage of an iron condor strategy is its high probability of profit. In part this is because the strategy is market neutral, meaning it doesn't matter whether the stock goes up or down in price. Profit is derived from the premiums collected from selling the two credit spreads of the iron condor. While this strategy creates limited profit, it also limits risk. 

"An iron condor reaches its maximum gain if the stock price closes in between the call and put options sold," says Kaufman. "Therefore, how you select these short strikes will dictate the credit received and the probability of reaching maximum gain."

How does an iron condor work? 

Recall that an iron condor is made up of four different options contracts that pair into two credit spreads, a bull put spread and a bear call spread. To create an iron condor, do the following:

• First select an expiration date. "While you can technically pick any amount of time to expiration, it's important to balance the time decay of the options with the ability to manage the trade," Kaufman advises. "That means choosing a date that is between 30 to 50 days to expiration."
• Then select which call and put options you will sell. "One approach is to consider the option's delta," says Kaufman. " Delta is a way of estimating the probability of the option expiring in-the-money (ITM) or profitable. If you were to select a call and put strike with a delta of 0.15 to 0.20 the call and put will have a 15% to 20% chance of expiring ITM. By following that rule, you will end up having a 60% to 70% probability of reaching maximum profit by expiration."
• Finally, determine which strikes to purchase as a protection against a major move in the price. Kaufman suggests caution: "Pick a call and put strike price that is one to two strikes further OTM. It's typical to have a $2 strike width between the long and short strike for most stocks."

Although it might sound a little counter-intuitive, an iron condor is most profitable when all four options expire out of the money. When one side or the other expires in the money, your losses can mount.

Iron condor example

Suppose you believe Microsoft shares, which were trading at $280, will not move much over the next 30 days. You decide to take out an iron condor with a 30-day expiration.

Here are the steps to do that:

1. Buy a long put with a strike of $248. Pay a $3.23 premium per share ($323 for one contract of 100 shares; $3,230 for 10 contracts).
2. Sell a short put with a strike of $250 and receive premiums of $3.61/$361/$3,610. 
3. Sell a short call with a strike of $320 and receive premiums of $3.41/$341/$3,410. 
4. Collect a premium of $3.41 ($341 for a contract of 100 shares). 
5. Buy a long call with a strike of $322 and pay premiums of $3.06/$306/$3,060.
6. Your total credit on all four legs is $0.73/$73/$730. This is the maximum profit you could make if all four options expire worthless. In order for you to make the profit, the price must be between $250 and $320 at expiration.

The table below shows actions taken along with metrics calculated by the OIC calculator and VFMDirect.com premium calculator.

Remember, based on delta, there's just an 18% probability of ending ITM on the put side and a 17% probability on the call side. This translates to an 82% to 83% likelihood the option will show maximum profit.

Although your maximum profit, in this case, is capped at $730 for a 10 contract iron condor, your maximum losses are also capped. The maximum loss is the difference between either the long call and short call strikes or the long put and short put strikes minus total credit times the number of shares being optioned.

In this case, the difference between the strike prices is $2/$200/$2,000, depending on contract size. For a 10 contract iron condor, the calculation looks like this: $2,000 - $730 or $1,270, maximum potential loss. It would be up to you to decide whether the "bet" is worth it given an 82-83% chance of success.