COMBINING CALL SPREADS and PUT SPREADS
Basic Framework - Iron Condors:
An iron condor strategy is an ideal way to not only define risk but to reduce the amount of total capital at risk. This reduction in capital requirements can maximize returns in options trading. This strategy involves combining both a call spread and a put spread. Hence, selling a call option and buying a call option while collecting a credit and selling a put option and buying a put option while collecting an additional credit. When combined, premium credits are collected on the call spread and the put spread for a collective premium credit. When selling the call/put spreads, premium is collected and simultaneously using some of that premium income to buy a call/put option at a further out-of-the-money strike price. The net result will be a credit on the four-leg trade with defined risk since the purchase of the call/put option legs serves as protection on either side of the trade.
By selling an iron condor, you agree to sell shares at the agreed upon price by the agreed upon expiration date (call side) and you agree to buy shares at the agreed upon price by the agreed upon expiration date (put side). By buying the call option, you have the right to buy shares at the agreed upon price by the same agreed upon expiration date and by buying the put option, you have the right to sell shares at the agreed upon price by the same agreed upon expiration date. Thus risk is defined and capital requirements are minimal since the underlying shares can only break through the call or put side of the trade. Max loss is confined to only one of the strike widths thus only half of the required capital is at risk.
An iron condor is a type of option trade that risk-defines your trade and involves selling a call spread and a put spread. Let’s review the iron condor as an example below.
Call Spread Side:
You agree to sell shares at the lower out-of-the-money strike until expiration of the contract. You also bought the right to buy the shares at the higher out-of-the-money strike that will serve as protection and define your risk. A portion of the premium income received from selling the lower strike was used to buy an out-of-the-money higher strike option. The difference in premium received and premium paid out for the protection is your net premium income. The difference between your strikes will be your max loss less the net premium received.
Put Spread Side:
You agree to buy shares at the higher out-of-the-money strike until expiration of the contract. You also bought the right to sell the shares at the lower out-of-the-money strike that will serve as protection and define your risk. A portion of the premium income received from selling the higher strike was used to buy an out-of-the-money lower strike option. The difference in premium received and premium paid out for the protection is your net premium income. The difference between your strikes will be your max loss less the net premium received.
The Trade Breakdown:
The call strike of $209 and put strike of $176 provide a margin of upside and downside of roughly 7.3% and 9.6%, respectively from current levels since shares are currently trading at $194.75 per share. As long as the shares remain between the $209 and $176 by expiration then both spreads will expire worthless.
Figure 1 – Opening an iron condor via selling a call spread and put spread combination while taking in net premium income during the process. Capital requirement is equal to the strike widths and maximum return is equal to the net premium received.
Potential Outcomes and Scenarios:
An iron condor with the same expiration dates will expire together worthless with defined risk if the underlying security remains between the out-of-the-money call and put strikes ($176 and $209). If the option expires between the call strikes or put strikes then losses will incur and if the stock moves above or below your protection strikes then a max losses will occur at expiration. A max loss is equal to one of the strike widths since the underlying security can't expire on both the call and put side of the trade. Thus max loss is equal to the strike width less the total premium received.
Selling an iron condor:
IWM Call Credit Spread: 22JAN21 @ $209 / 22JAN21 @ $211
IWM Put Credit Spread: 22JAN21 @ 176 / 22JAN21 @ 174
Per Contract Premium: Call Credit + Put Credit = $0.34
Required Capital Per Contract:
Call: ($209 - $211) = $200
Put: ($176 - $174) = $200
$200 call spread + $200 put spread - Net Premium of $34 = $366
A) If the stock stays below $209 and above $176 at expiration then you net the $34 in premium and all four option legs co-expire worthless with 100% premium capture
B) If the stock trades above $209 or below $176 then you begin losing money but the $211 and $174 strike legs cap any losses above $211 or below $174. If the stock falls between your strike width at ~$210 or ~$175 then a loss of $1 per share less the premium received of $0.34 per share will be your realized loss ($100 - $34 = $66 loss per contract).
C) If the stock trades above the call protection leg of $211 or the put protection leg of $174, losses are now capped at your strike width of $2 per share. If you were assigned at $209 or $176, you would then exercise your $211 or $174 strike option and buy shares at $211 or sell shares at $174 to cap losses at $2 per share less premium received of $34 resulting in a max loss of $166. Even if the stock was to rise to infinity or decline to zero, you have the right to buy shares at $211 or sell shares at $174 so any losses above $211 or below $174 are prevented.
Closing Iron Condors:
Although iron condors can co-expire worthless to capture 100% of the premium, managing winning trades may be necessary. Reversing the process via buying-to-close the option leg that was sold-to-open and then selling-to-close the put protection leg that was bought-to-open across both spreads is necessary. This will allow you to close trades early in the option life cycle and realize gains.
Options are a leveraged vehicle thus minimal amounts of capital can be deployed to generate outsized gains with predictable outcomes. An iron condor strategy is an ideal way to balance risk and reward in options trading since capital at risk is half that of a stand alone call spread or put spread.