A friend of mine told me about an online options class he was taking in which the teacher praised the iron condor strategy while dissing my favorite trade, the covered call — both are designed to generate a credit with minimal risk amid a neutral market.
The iron condor is somewhat complicated. You sell 1 out-of-the-money put, buy 1 OTM put at a lower strike, sell 1 OTM call and buy 1 OTM call at a higher strike. The maximum gain for the iron condor strategy is equal to the net credit received when entering the trade, and is attained when the underlying stock price at expiration is between the strikes of the short put and short call. At this price, all the options expire worthless.
So, max profit is simply calculated as Net Premium Received – Commissions Paid.
On the risk side, the maximum loss is limited but higher than the maximum profit. It occurs when the stock price falls at or below the lower-strike put you bought or rises above or equal to the higher-strike call you bought.
Thus, max loss is calculated as Long Call Strike – Short Call Strike – Net Premium Received + Commissions.
So let’s test this with Coca-Cola for the April expiration. At this writing, Coke trades at $38.68. The iron condor approach would be:
- Sell 37.50 Put for 44 cents.
- Buy 36.25 Put for 21 cents.
- Sell $37.50 Call for $1.38.
- Buy $38.75 Call for 70 cents.
- Net Credit = $0.91.
- Max Profit = $91 (on a 100-share contract) – $32 commission = $59 credit. I hope for a neutral market, and for Coca-Cola to end at $37.50.
- Maximum loss = $38.75 – $37.50 – $0.59 = $0.66, or $66 max loss (on a 100-share contract).
Now, let’s say instead I just buy the underlying 100 shares of KO at $38.68, then sell the $38.75 call for 70 cents. My net profit here is $62, including commissions. So the upside is a little better than the iron condor strategy. My downside is theoretically unlimited, in that Coke could plummet for any number of reasons. However, for me to experience a loss of $66, KO would have to hit $37.32 at expiration.
In theory, then, the iron condor does limit your upside and your downside.
However, there’s one thing this strategy doesn’t take into account, and it’s the reason I prefer the covered call.
If you use this strategy on a blue-chip stock that you would like to own, or wouldn’t mind owning — a company that is never going to go bankrupt — then your downside is actually limited. You just have to be willing to hold onto Coca-Cola until the stock returns to where you purchased it. Assuming you haven’t vastly overpaid for it (you aren’t at this price), then the worst-case scenario is it’ll just take time.
In the meantime, you could continue to sell calls against it to lower your effective purchase price. And if the stock doesn’t get called away, yet ends up close to your purchase price, you can also sell the call again.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at firstname.lastname@example.org and follow his tweets @ichabodscranium.