Options and option spreads can add versatility to your methods of trading, but some of the spread techniques can be complicated - if not downright intimidating. Here, we will explore one of the popular and often misunderstood option spread techniques - the Iron Condor.

An Iron Condor is a spread that can be profitable in a market that does not have much price movement. Iron Condors carry predefined risk and offer predefined profit potential without directional bias. An Iron Condor spread strategy has multiple legs, and therefore, multiple commissions and fees associated with it which must be taken into account when determining breakeven points and net costs. Spreads are no less risky than outright option positions. An Iron Condor is constructed with two familiar option spread techniques that do have directional bias. These are the bull put and bear call spreads.

A bull put spread is - as the name implies - a spread that may result in a profit when the market moves up. A "bullish" outlook on the market might motivate a trader to implement a bull put spread. Bull put spreads are "vertical" spreads and involve two options on the same underlying market with the same expiration date but different strike prices, hence the "vertical." In a bull put spread, you would sell one of the puts and buy another with a lower strike price. Since the option that you sell is nearer to the underlying market's price, it would have a higher premium. As a result, initiating a bull put spread produces a net premium credit. For this reason, a bull put spread is known as a "credit spread." When a credit spread is initiated, the net credit that is generated is the maximum potential profit on the trade (minus any fees and commissions). The maximum risk for a bull put credit spread is the difference between the strike prices minus the net credit received (plus any fees and commissions). Like the bull put spread, a bear call spread is a vertical spread constructed with two options on the same underlying market with the same date of expiration. Bear call spreads sell a call and at the same time buy another call with a higher strike price. The resulting net credit is the maximum profit for this trade (minus any fees and commissions). The maximum risk with a bear call spread is the difference between the strike prices minus the net credit received (plus any fees and commissions). This "bearish" strategy aims to collect profits in the event that the underlying market moves lower. Both the bull put spread and the bear call spread offer premium collection against a particular market bias with a defined price level at which maximum risk exposure is reached.

Sell one out-of-the-money put Buy one further out-of-the-money put    (with a lower strike price than the short put) Sell one out-of-the-money call Buy one further out-of-the-money call    (with a higher strike price than the short call)

The inside (or short options) are often referred to as the wings. Since the two short options are closer-to-the-money, the condor spread will result in a net credit rather than a debit. The maximum profit excluding commissions and fees is the net credit received on the trade. Commissions and exchange fees can be an important part of the risk and reward calculations for an Iron Condor since the spread involves four option contracts. Because the trade is constructed with net short option strategies, margin requirements will likely apply.

An Iron Condor can be entered into all at one time, or the two vertical spreads (the bull put and bear call spreads) can be used to construct one. Legging into the trade with two vertical spreads may expose you to reduced net credit, as adverse market movements in these directionally sensitive spreads or volatility contraction could reduce option premiums.

The maximum risk for an Iron Condor is the difference between the strike prices in the bull put and bear call spread minus the net credit received on the trade (excluding commissions and fees). Maximum risk is realized if the price of the underlying contract meets or exceeds either long option strike price.

There are two breakeven points in an Iron Condor spread. Excluding commissions and fees, the breakeven to the downside would be the strike price of the short put minus the net credit received.

To the upside (excluding commissions and fees), the breakeven would be the strike price of the short call plus the net credit received.

The goal of an Iron Condor is to have the underlying contract at or between the inner strike prices at expiration. An Iron Condor is without directional bias since movement in the price of the underlying contract in either direction can affect one side of the trade. Unlike other nondirectionally biased option spreads that can produce unlimited risk exposure, the long options on the outside of an Iron Condor provide a measure of risk management and define the overall risk exposure. If the underlying market moves significantly in either direction and beyond the breakeven point, exposure to loss continues through to the strike price of the corresponding long option.

Volatility also plays a large role in constructing an Iron Condor. These spreads are often implemented in markets with higher implied volatility levels when the option writer forecasts contracting or lower volatility.

Ideally, an Iron Condor strategy would be implemented with options nearer to expiration since the steeper time decay curve may be beneficial, and forecasting a flat market with lower volatility becomes more difficult over a longer time frame.

Futures and options trading involves substantial risk of loss and is not suitable for all investors. Past performance is not indicative of future results.