Deriving Iron Condor

Let’s talk about Short Straddle which gives us a range for where we can get our profit. NIFTY 50 is at 9837.4 right now.

Short Straddle

Here is our straddle of 9800 CEPE.

straddle

Here is a short strangle of 9800 PE and 9850 CE. But it is very close to our straddle’s work. It gives us a range where our profit lies.

But both have an unlimited downside! How can we convert them to limited loss? Let’s work separately –

short strangle

For 9800 PE we can just buy PE at the lower strike price (OTM). So buy 150 points away i.e. 9650 PE.

Strike price

Well, it limited the unlimited loss part but we had to sacrifice a significant amount of profit for doing so too because the put option premium debited will be a loss if the trade moves into our direction (i.e upside as we are betting on 9800 PE sell).

What we did here is Sell OTM Put (closer to spot) – Buy OTM Put (away from the spot) which is also known as Short Put Vertical Spread!

Similarly, let’s look at 9800 CE –

Short Put Vertical Spread

To limit unlimited loss; let’s buy a call option at a higher strike price which is at a lower premium as it is away above from the strike price. Let’s buy 150 points away i.e. 10000 CE

Short Put Vertical Spread

Well, it limited the unlimited loss part but we had to sacrifice a significant amount of profit for doing so too because the call option premium debited will be a loss if the trade moves into our direction (i.e downside as we are betting on 9850 CE sell).

What we did here is Sell OTM Call (closer to spot) – Buy OTM Call ( away from the spot) which is also known as Short call Vertical Spread!

So combining Short put Vertical Spread and Short call Vertical Spread gives us our short straddle with limiting the unlimited loss part.

This is called Iron Condor. Let’s combine both setups into one –

  • Short Put Vertical Spread
  • Short Call Vertical Spread

Short Put Vertical Spread – Sell 9800 PE; Buy 9650 PE

Short Call Vertical Spread – Sell 9850 CE; Buy 10000 CE

Short Call Vertical Spread

So it has a range of profit as well as our loss is limited too.

So summing up the entire discussion into one picture –

So we can also shift our strike prices to see modifications of our Payoff Graph –

Ideal Implied Volatility Environment: High; It’s a short-selling setup hedged towards the downside.

Max Profit: The maximum profit potential for an Iron Condor is the net credit received. Maximum profit is realized when the underlying settles between the short strikes of the trade at expiration.

Max Loss:

Short Put Strike – Long Put Strike – Credit Received or,

Long Call Strike – Short Call Strike – Credit Received

Max Loss Occurs When Price of Underlying >= Strike Price of Long Call OR Price of Underlying <= Strike Price of Long Put

How to Calculate Breakeven(s):

  • Upside: Short Call Strike + Credit Received
  •  Downside: Short Put Strike – Credit Received

Short Put Vertical Spread – Sell 9800 PE; Buy 9650 PE

Short Call Vertical Spread – Sell 9850 CE; Buy 10000 CE

Net Credit Received = (67.85+85.95) – (31.85+27.10) = 94.85

Here our upside breakeven is = 9850 + 94.85 = 9944.85

Here our downside breakeven is = 9800 – 94.85 = 9705.15

Max Profit = 94.85

Max Loss = (9800-9650) -94.85 = (10000-9850) -94.85 = 55.15

Max Loss Occurs When Price of Underlying >= 10000 OR Price of Underlying <= 9650

We look to ladder up or ladder down towards the untested spreads closer to the stock price to collect more premium.

If we make a rough picture of our strategy replacing strike price points as A, B, C, D –

iron condor
The distance between strikes A and B is usually the same as the distance between strikes C and D (Here we choose it as 150). However, the distance between strikes B and C may vary to give you a wider sweet spot.

You may wish to consider ensuring that strike B and strike C are around one standard deviation or more away from the stock price at the initiation. That will increase your probability of success. However, the further these strike prices are from the current stock price, the lower the potential profit will be from this strategy.

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