The Iron Condor
A variation on the iron butterfly is the “iron condor”. We have already seen that an iron ‘fly comprises a straddle traded against a strangle. An iron condor comprises a narrow strangle traded against a wider strangle. The rationale behind an iron condor is identical to that behind the iron ‘fly. We want to sell options because we think that they are overpriced and we think that the underlying will stay around its current level. As a result, we decide to sell strangles. The problem is that selling naked strangles equates to unlimited risk. We are unwilling to accept this so we buy a wider strangle around our short strangle to protect it. The result is that potential losses are limited, albeit at the cost of lower potential profit. Consider an example of a short iron condor using the Sep BP option prices shown in Table 24.1 (repeated from Table 16.1).
Our view is that market volatility is currently too high and, as a result, the Sep options are overpriced. Our view on the underlying is that BP will stay between about 500 (i.e. £5.00) and 540 (i.e. £5.40) between now and Sep expiry. As a result of these views, we sell the Sep 500/540 strangle at 39 (i.e. we sell the 500 put at 20 and the 540 call at 19) and buy the wider Sep 480/560 strangle at 26 (i.e. we buy the 480 put at 14 and the 560 call at 12) against it. Our net credit on the whole trade is 13 (we receive 39 for selling the 500/540 strangle and pay out 26 for the 480/560 strangle) per iron condor sold. ...