Reverse Iron Condor Explained

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Reverse Iron Condor Strategy

The Reverse Iron Condor (RIC) is a limited risk, limited profit trading strategy that is designed to earn a profit when the underlying stock price makes a sharp move in either direction. The RIC Spread is where you buy an Iron Condor Spread from someone who is betting on the underlying stock staying stagnant.

Introduction

Reverse Iron Condor Construction

  • Buy 1 OTM Put
  • Sell 1 OTM Put (Lower Strike)
  • Buy 1 OTM Call
  • Sell 1 OTM Call (Higher Strike)

Reverse Iron Condor has a limited gain and a limited loss potential. The maximum gain It is attained when the underlying stock price drops below the strike price of the short put or rise above or equal to the higher strike price of the short call. In either situation, maximum profit is equal to the difference in strike between the calls (or puts) minus the net debit taken when initiating the trade. It will result in a loss if the price doesn’t move far enough in either direction, or if it stays the same.

Compared to a straddle option strategy, RIC has limited gain potential, but it also needs the stock to move less to be profitable. It is basically a combination of bull call debit spread and bear put debit spread. You can adjust the strikes based on your expectation of the move. Constructing the trade with further OTM options will provide a better risk/reward, but lower probability of success (the stock will need to move more to produce a gain).

One of the common uses of the Reverse Iron Condor strategy is betting on a sharp move on one of the high flying stocks after earnings. It can be used on stocks like NFLX, AMZN, GOOG, TSLA, PCLN etc.

Using Reverse Iron Condor through Earnings

GOOG was scheduled to report earnings on April 21, 2020. The At-The-Money weekly straddle ($760 strike) was trading around $41, implying $41 or 5.3% move.

If you believed that GOOG is going to move, you had two options:

Option #1: buy a straddle for $41 debit

  • Buy 1 760 Put
  • Buy 1 760 Call

Option #2: buy RIC (Reverse Iron Condor) for 1.75 debit

  • Buy 1 745 Put
  • Sell 1 740 Put (Lower Strike)
  • Buy 1 775 Call
  • Sell 1 780 Call (Higher Strike)

Straddle would need $41 move just to break even, but would have unlimited profit potential if the stock moved big time. It also would not lose as much if the stock moved less than expected.

RIC would need only $20 move (above $780 or below $740) to make money.

The next day GOOG moved $40 and closed at $719. Since it was below the short put strike, the RIC made a nice 43% gain (2.50/1.75), while the straddle was barely breakeven.

The Risks

The biggest drawdown of the RIC strategy before earnings is that if the stock doesn’t move enough after earnings, IV collapse will crush the options prices. The risk of 80-100% loss is real.

Unfortunately, many options gurus present this strategy as almost risk free money, completely ignoring the risks. Here are two examples.

A Seeking Alpha contributor suggested the following play on GOOG earnings on April 12, 2020 with GOOG at $632:

  • Buy twenty (20) April Week 2 $610.00 put options
  • Sell twenty (20) April Week 2 $600.00 put options
  • Buy twenty (20) April Week 2 $650.00 call options
  • Sell twenty (20) April Week 2 $660.00 call options

Rationale behind the trade:

“Google is a notorious big-mover after reporting. I am completely confident that the trade recommendation I am writing about will work like a charm.

What is completely missing in this comment is the disclosure of the options trading risk. The next day GOOG closed at $624, and the trade has lost 100%.

As our contributor Chris (cwelsh) mentioned in the comments section:

“Earnings are wild and unpredictable. A careful analysis and you can improve your odds, but you always have to factor in position sizing and potential loss into any trade. My entire point of my posts was that I think a discussion of risks should always be included in any article that discusses huge potential gains.”

I recommend reading the comments section of the article, it can tell a lot about different people’s approaches to trading and risk.

The second example is from a website that is using the strategy cycle after cycle. Here is the quote:

“The Debit Iron Condor is used primarily on stocks that have a long history of big moves when announcing their quarterly earnings. We have a very good idea of how big the move will be, in one direction or the other. And the amazing thing about studying history is that history truly repeats itself, and that means a big percentage of wins. The magic works when the Debit Iron Condor is combined with big moves from stocks on earnings day.”

The problem is, once again, complete lack of disclosure of the option trading risk. Even if the “history truly repeats itself” 80% of the time, in 20% of the cases when it doesn’t, the strategy can lose 100%. Big percentage of wins means nothing if your losers are much higher than the winners, and you can do nothing to control the losers due to IV collapse.

One way to reduce the risk is using more distant expiration instead of the weekly options. The closer the expiration, the bigger the impact on trade. There is a trade off with respect to time, move and implied volatility drop. If the stock doesn’t move, the further expiration trade will lose less because there still will be some time value left. On the other hand, if it does move, the gains will be less as well, and you will have to wait longer to realize the full potential.

Unfortunately, we tried this strategy too in 2020, and the results were pretty bad. You can read more here. We don’t hold those trades through earnings anymore, but we do use the strategy before earnings and make sure to be before the earnings announcement.

The Bottom Line

If you expect a stock to move significantly but don’t want to bet on direction, Reverse iron Condor is a good strategy to implement. The maximum profit and the maximum loss are both predictable, and you can adjust the strikes based on your expectation how much you the price will move.

This strategy can be successfully used for trading stocks with history of big moves. GOOG, NFLX, AMZN, TSLA, BIIB are good candidates. However, earnings are unpredictable, and you need to control the risk with proper position sizing. It is definitely possible to lose 100% with this strategy. I would define it as high probability high risk strategy.

One of the members asked me on the forum if we are going to play GOOG and AMZN with RIC. Based on earnings uncertainty and our bad experience earlier this year, I decided to skip. It was a good call. GOOG RIC would be a 100% loser, and AMZN would be a borderline as well, depending on the strikes.

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    Those who are nearing retirement and those who have recently retired represent the majority of my financial planning and investment advisory client base. One of the most common mistakes I hear from these types of individuals is something similar to “I no longer have enough time for the market to come back.”

    The Iron Condor

    You may have heard about iron condors, a popular option strategy used by professional money managers and individual investors. Let’s begin by discussing what an iron condor is, and then how you can benefit from learning how to trade them.

    What Is an Iron Condor?
    An iron condor is an options strategy that involves four different contracts. Some of the key features of the strategy include:

    • An iron condor spread is constructed by selling one call spread and one put spread (same expiration day) on the same underlying instrument.
    • All four options are typically out-of-the-money (although it is not a strict requirement).
    • The call spread and put spread are of equal width. Thus, if the strike prices of the two call options are 10 points apart, then the two puts should also be 10 points apart. Note that it doesn’t matter how far apart the calls and puts are from each other.
    • Most often, the underlying asset is one of the broad-based market indexes, such as SPX, NDX or RUT. But many investors choose to own iron condor positions on individual stocks or smaller indexes.
    • When you sell the call and put spreads, you are buying the iron condor. The cash collected represents the maximum profit for the position.
    • It represents a ‘market neutral’ trade, meaning there is no inherent bullish or bearish bias.

    Iron Condor Positions, Step by Step

    To illustrate the necessary components or steps in buying an iron condor, take the following two hypothetical examples:

    To buy 10 XYZ Oct 85/95/110/120 iron condors:

    • Sell 10 XYZ Oct 110 calls
    • Buy 10 XYZ Oct 120 calls
    • Sell 10 XYZ Oct 95 puts
    • Buy 10 XYZ Oct 85 puts

    To buy three ABCD Feb 700/720/820/840 iron condors:

    • Sell three ABCD Feb 820 calls
    • Buy three ABCD Feb 840 calls
    • Sell three ABCD Feb 720 puts
    • Buy three ABCD Feb 700 puts

    How Do Iron Condors Make/Lose Money?

    When you own an iron condor, it’s your hope that the underlying index or security remains in a relatively narrow trading range from the time you open the position until the options expire. When expiration arrives, if all options are out-of-the-money, they expire devoid of worth and you keep every penny (minus commissions) you collected when buying the iron condor. Don’t expect that ideal situation to occur every time, but it will happen.

    Sometimes it’s preferable to sacrifice the last few nickels or dimes of potential profit and close the position before expiration arrives. This allows you to lock in a good profit and eliminate the risk of losses. The ability to manage risk is an essential skill for all traders, especially ones employing this strategy.

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    The markets are not always so accommodating, and the prices of underlying indexes or securities can be volatile. When that happens, the underlying asset (XYZ or ABCD in the previous examples) may undergo a significant price change. Because that’s not good for your position (or pocketbook), there are two important pieces of information you must understand:

    • How much you can lose; and
    • What you can do when the market misbehaves.

    Maximum Loss Potential

    When you sell 10-point spreads (as with XYZ), the worst-case scenario occurs when XYZ moves so far that both calls or puts are in the money (XYZ is above 120 or below 85) when expiration arrives. In that scenario, the spread is worth the maximum amount, or 100 times the difference between the strike prices. In this example, that’s 100 x $10 = $1,000.

    Because you purchased 10 iron condors, the worst that can happen is that you are forced to pay $10,000 to cover (close) the position. If the stock continues to move further, it won’t affect you further. The fact that you own the 120 call (or 85 put) protects you from further losses because the spread can never be worth more than the difference between the strikes.

    Loss Buffer in Premiums

    There’s some better news: Remember, you collect a cash premium when buying the position, and that cushions losses. Assume you collect $250 for each iron condor. Subtract that $250 from the $1,000 maximum, and the result represents the most you can lose per iron condor. That’s $750 in this example.

    Note: If you continue to hold the position until the options expire, you can only lose money on either the call spread or the put spread; they cannot both be in-the-money at the same time.

    Depending on which options (and underlying assets) you choose to buy and sell, a few different circumstances can come about:

    • The probability of loss can be reduced, but reward potential is also reduced (choose further out-of-the-money options).
    • Reward potential can be increased, but the probability of earning that reward is reduced (choose options that are less far out-of-the-money).
    • Finding options that fit your comfort zone may involve a bit of trial and error. Stick with indexes or sectors that you understand very well.

    Introduction to Risk Management

    The iron condor may be a limited-risk strategy, but that doesn’t mean you should do nothing and watch your money disappear when things don’t go your way. Although it’s important to your long-term success to understand how to manage risk when trading iron condors, a thorough discussion of risk management is beyond the scope of this article.

    Just as you don’t always earn the maximum profit when the trade is profitable (because you close before expiration), you often lose less than the maximum when the position moves against you. There are several reasons that this might occur:

    • You may decide to close early to prevent larger losses.
    • XYZ may reverse direction, allowing you to earn the maximum profit.
    • XYZ may not move all the way to 120. If XYZ’s price at expiration (settlement price) is 112, then the 110 call is in-the-money by two points and is worth only $200. When you buy back that option (the other three options expire without worth), you may still have earned a small profit – $50 in this scenario.

    Practice Trading in a Paper-Trading Account

    If this strategy sounds appealing, consider opening a paper-trading account with your broker, even if you are an experienced trader. The idea is to gain experience without placing any money at risk. Choose two or three different underlying assets, or choose a single one using different expiration months and strike prices. You’ll see how different iron condor positions perform as time passes and markets move.

    The major objective of paper trading is to discover whether iron condors suit you and your trading style. It’s important to own positions within your comfort zone. When the risk and reward of a position allow you to be worry-free, that’s ideal. When your comfort zone is violated, it’s time to modify your portfolio to eliminate the positions that concern you.

    Summary

    Iron condors allow you to invest in the stock market with a neutral bias, something that many traders find quite comfortable. This options strategy also allows you to own positions with limited risk and a high probability of success.

    Iron Condors Explained

    Iron Condors are defined risk strategies with two break-even-points. They are one of the most commonly used option strategies.

    Video Breakdown:

    Short Iron Condor Strategy

    Market Assumption:

    When trading Short Iron Condors you should have a neutral/range bound market assumption. This means you hope for relatively small or no move at all in the underlying. Short Iron Condors can be very slim (just a few strikes apart) or very wide (far apart strikes) depending on your assumption. Many people including me use Short Iron Condors with two high probability strikes as a high probability strategy.

    Setup:

    • Buy 1 OTM Put
    • Sell 1 OTM Put (higher strike)
    • Sell 1 OTM Call
    • Buy 1 OTM Call (higher strike)

    This should result in a credit (You get paid to open).

    Profit and Loss:

    As you can see on the payoff-diagram a Short Iron Condor isn’t just a defined risk trade, but also a defined profit trade. The maximum profit is achieved when the underlying price is somewhere between the two short strikes. The maximum loss occurs when the price is anywhere outside of the two long strikes. It doesn’t matter if the price is $10 or $100 outside of the profitable range because the two long options on both sides act as a hedge. The maximum loss is higher than the maximum profit.

    Maximum Profit: Premium received – Commissions

    Ex. $20 Premium – $3 Commission = $17 (max profit)

    Maximum Loss: Width of Call Strikes * 100 – Premium Received + Commissions Paid

    Ex. (Call Strikes: 50 and 52) => $2 Width * 100 – $20 Premium + $3 Commissions = $183 (max loss)

    (a normal option contract controls 100 shares, therefore *100)

    Implied Volatility and Time Decay:

    A Short Iron Condor profits from a drop in Implied Volatility (IV), because the options sold then lose value. Therefore, it is best to use this strategy in times of high IV (IV rank over 50).

    Time Decay also works in favor of this strategy. The more time goes by the more the sold options lose in their extrinsic value. The time decay for each day increases the closer you get to expiration.

    Long Iron Condor Strategy/Reverse Iron Condor

    Market Assumption:

    When trading a Long Iron Condor (aka. Reverse Iron Condor) you would expect a relatively big move in a short period of time, but you don’t quite know in which direction this move will be. The bigger a move you expect, the further the long strikes have to be apart. This strategy isn’t used that often but can be quite profitable when used correctly. But keep in mind it is much harder to predict an unusual big move than predicting something to stay range-bound.

    Setup:

    • Sell 1 OTM Put
    • Buy 1 OTM Put (higher strike)
    • Buy 1 OTM Call
    • Sell 1 OTM Call (higher strike)

    This should result in a Debit (You pay to open)

    Profit and Loss:

    This also is a defined risk/profit strategy. Maximum profit is achieved when the price of the underlying asset moves further than one of the short positions. It doesn’t matter if it’s above the highest strike or below the lowest. Maximum loss, on the other hand, occurs when the price stays at the same position or just moves a little (stays between the two long options). For long Iron Condors, the max profit exceeds the max loss.

    Maximum Profit: Width of Call Strikes * 100 – Premium Paid + Commissions Paid

    Ex. (Call Strikes: 50 and 52) => $2 Width * 100 – $20 Premium + $3 Commissions = $183 (max profit)

    Maximum Loss: Premium paid + Commissions

    Ex. $17 paid to open + $3 commission = $20 (max loss)

    Implied Volatility and Time Decay:

    Just like in the other categories a Long Iron Condor also here is just the opposite of a Short Iron Condor. It profits from a rise in IV, therefore should be bought in times with relatively low IV (IV rank under 50).

    Time decay works against a Long Iron Condor because the Long options lose a bit of value every day. They lose more and more value the closer you get to expiration.

    Trader’s Note:

    Iron Condors are a very useful, popular and profitable option strategy. Together with Credit Spreads, Short Iron Condors make up the easiest and best strategies for high probability trading. Short Iron Condors are a range bound strategy, profiting from no or small moves in the underlying price. If you set your strikes out far enough, these spreads will have a high chance of being profitable. The further you go OTM with your strikes, the higher your probability of success will become. But your max loss will rise and your max profit will decrease. When used correctly, Iron Condors can be very profitable and that is the reason why I use them and do recommend them in my training as well (check out my training here).

    A Long Iron Condor, on the other hand, is more of a directional strategy. Even though it is not bullish or bearish, it needs the price to move to be profitable. You don’t care in which direction as long as the price moves far enough. Long Iron Condors are best used in times where a big move may stand ahead, but it is unclear in which direction this move will be. This could be the case for special events like earnings, elections, referendums, big market announcements… The further you set your strikes away from the underlying trading price, the lower your probability of profit will become, but your profit potential will rise.

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    9 Replies to “Iron Condors Explained”

    Wow!! I have traded stocks before and have never understood this. That was explained very well. I will be watching your sight in the near future to understand it better. Thanks for sharing this knowledge

    Hey Kim,
    So so glad that you are learning more and enjoying my site.

    So I see the iron condor is a strategy that involves the combination of two vertical spreads. So in the case of a short iron condor, rather than saying that you believe a stock will move in a direction, are we saying that we think the stock will stay within certain upper and lower limits? And visa versa for the long? Rather than stay in a range, we want it to go up or down. Either one would be fine, right? What kind of probabilities are you shooting for when you apply an iron condor?

    Thank you for your help!

    That is correct. The short iron condor is a range bound strategy, whereas the long iron condor is a price indifferent strategy (you don’t care where the price moves, as long as it moves). I only trade short iron condors and usually aim at a probability of ITM of 70%.

    I like it! Thanks for being responsive to comments as well. So a 70% probability of being in the money. How many days until expiration do you usually like to sell at? Do you stick with monthly or do you use weeklies?

    Hey once again,
    I normally stick to monthly contracts and enter iron condors around 30 days before expiration. But I actually trade much more credit spreads than iron condors. If you want to learn my entire option strategy (option premium selling), you could also check out my intermediate course here. In there I thourougly explain how I make money with options.
    If you have any further questions, I would be happy to answer them.

    Glad found your website here to learn option. Do u think to trade Iron Condor we should find 30% Prob ITM instead of 70% Prob ITM as taught by Sky View Trading?. Please help me to explain this.Thanks.

    Hi Harry,
    Thanks for your question. I recommend focusing on the probability of profit (POP) instead of the probability of ITM. The probability of profit tells you what the probability of actually making money is, whereas the probability of ITM doesn’t. Your overall POP on a short Iron condor should ideally be over 50%.
    I recently wrote an entire article about the different options trading probabilities. So make sure to check that out for a more detailed explanation of all the different probabilities.
    Hopefully, this helps. Please let me know if you have any other (follow-up) questions or comments).

    Glad I found your website to lear Option. hmmm do you think we should find 30% Prob ITM instead of 70% Prob ITM taught by Sky View Trading. Please help me explain about this.Thanks

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