Iron Condor - Cost involved

[moolah]

I am new to iron condor, just would like to know what is the costs involved and potential profit when entering a iron condor trade? My understanding is costs involved is the 2 BUY trades, one on the put side and one one the call side. Potential profit is when all 4 legs expires without being triggered / exercise. Please correct me if i am wrong.

Also if one is to analyse a iron condor trade, yours costs involved is more then your potential profit. That does not make sense to me.

Most grateful if someone can explain to me.

 

[Lee-]

You are correct. Your costs are the cost of purchasing the outer legs and your profit is from the sell of the inner legs. Of course there's commissions, exchange fees, regulatory costs, etc as well just like with any other options trade.

Generally, with an iron condor you get to pick your max profit (within reason) and max loss (within reason) by selecting appropriate legs. If what you're calculating is showing expenses greater than max profit, then you need to take on more risk (move the inner legs in closer and the outer ones further away). While this will increase risk, it will also increase premiums received on the legs you sell as well as reduce costs on the legs you buy.

This is basically the name of the game when it comes to options. The higher the profit potential, the more risk you must assume (in terms of max loss, statistical odds of the trade going against you, or both).

By moving the inner legs closer together, you are betting that the underlying will stay within a smaller range. This makes it more likely that the trade will go against you, but this additional risk allows you to get higher premium by selling closer to the money strikes. Similarly, by buying strikes further out, you are reducing the cost of those contracts, but you are also increasing max loss.

If you thought iron condors were some holy grail of risk free profits, think again. No such thing exists. I'd strongly recommend you paper trade these before going live.

EDIT: having re-read your post, I'm thinking perhaps you were not seeing a positive max profit because you had mixed up which contracts to buy/sell. I'll give an example. This is purely for illustration purposes and I am not recommending you (or anyone) do this particular trade:

TSLA is at $342.9
BUY put strike of $325 expiration of 10/27 at a price of $4.65
SELL put strike of $335 expiration of 10/27 at a price of $7.35
SELL call strike of $350 expiration of 10/27 at a price of $7.90
BUY call strike of $360 expiration of 10/27 at a price of $5.10

To initiate this trade (ignoring commissions and other fees) you will pay out $9.75 ($5.10 + $4.65) for the contracts you buy and you will receive $15.25 ($7.9 + $7.35) for the contracts you sell, for a net credit of $5.5/share. This is your maximum profit. Your maximum loss is $10 - $5.5 = $4.5.

 

[moolah]

In your maximum loss equation of $10 - $5.5, what is the rationale behind the ' - $5.5 ' part? Is it due to the credit received when the trade was initiated?

You are correct. Your costs are the cost of purchasing the outer legs and your profit is from the sell of the inner legs. Of course there's commissions, exchange fees, regulatory costs, etc as well just like with any other options trade.

Generally, with an iron condor you get to pick your max profit (within reason) and max loss (within reason) by selecting appropriate legs. If what you're calculating is showing expenses greater than max profit, then you need to take on more risk (move the inner legs in closer and the outer ones further away). While this will increase risk, it will also increase premiums received on the legs you sell as well as reduce costs on the legs you buy.

This is basically the name of the game when it comes to options. The higher the profit potential, the more risk you must assume (in terms of max loss, statistical odds of the trade going against you, or both).

By moving the inner legs closer together, you are betting that the underlying will stay within a smaller range. This makes it more likely that the trade will go against you, but this additional risk allows you to get higher premium by selling closer to the money strikes. Similarly, by buying strikes further out, you are reducing the cost of those contracts, but you are also increasing max loss.

If you thought iron condors were some holy grail of risk free profits, think again. No such thing exists. I'd strongly recommend you paper trade these before going live.

EDIT: having re-read your post, I'm thinking perhaps you were not seeing a positive max profit because you had mixed up which contracts to buy/sell. I'll give an example. This is purely for illustration purposes and I am not recommending you (or anyone) do this particular trade:

TSLA is at $342.9
BUY put strike of $325 expiration of 10/27 at a price of $4.65
SELL put strike of $335 expiration of 10/27 at a price of $7.35
SELL call strike of $350 expiration of 10/27 at a price of $7.90
BUY call strike of $360 expiration of 10/27 at a price of $5.10

To initiate this trade (ignoring commissions and other fees) you will pay out $9.75 ($5.10 + $4.65) for the contracts you buy and you will receive $15.25 ($7.9 + $7.35) for the contracts you sell, for a net credit of $5.5/share. This is your maximum profit. Your maximum loss is $10 - $5.5 = $4.5.

 

[Lee-]

In your maximum loss equation of $10 - $5.5, what is the rationale behind the ' - $5.5 ' part? Is it due to the credit received when the trade was initiated?

Let's say the stock goes to $400/share (you can do the same with stock going to $300, just use the puts instead of the calls for your calculation). You lose $50/share on the $350 strike you sold ($400 - $350), but the call you bought on the $360 strike is "protective" meaning it caps your loss to $10/share ($360 - $350) -- or to think of it another way, you lose $50/share on the call you sold, but you make $40/share on the call you bought. So your actual loss would be $10/share, right? Well no, because you received $5.5 in credits from all your options trades ($15.25 from selling the put and call - $9.75 for buying the put and the call). As such, by opening the iron condor position, you start out your position up $5.5.

By buying a call option further out (higher strike), the cost would be lower, which means your net credit when you open the position is higher, but lets say you did a $370 strike, then your max loss is $20 on the call spread - $5.5 = $14.5. Sure it increases your max profit by way of reducing the cost of your call, but it opens you up to a higher max loss. You have to make the decisions on which strikes you choose, which underlying, which expiration, etc based on your evaluation of the underlying, risk tolerances, and everything else that goes in to trading.