Long Iron Condor Option Trade

We have structured a trade that results in tying up $1,270 in margin capacity for 13 trading days. This money will not actually be borrowed (thus, there will be no interest expense on it) unless a loss is incurred. Initially, there will be no change in margin borrowing capability because this type of trade is known as "net credit", that is you end up with more cash in your account than you had before you entered into it. The maximum potential gain is $734.14. The maximum potential loss is $1,270, which would begin to be taken out of margin as it was incurred.

The transaction resulted in 4 trades being placed, each covering 10 contracts. The trades are all for Wells Fargo & Company, expiring on May 16th, 2009.

Part 1:

• Buy $24.00 Call. Option Symbol: FHUEX. Total Cost: $0.40
• Sell (Write) $22.50 Call. Option Symbol: WFCEX. Total Premium Earned: $0.80
• Total Net Premium Earned: $0.40

Part 2:

• Buy $16 Put. SYMBOL: WFCQF. Total Cost: $0.80
• Sell (Write) $18 Put. SYMBOL: WFCQK. Total Premium Earned: $1.38
• Total Net Premium Earned: $0.58

Grand Total Net Premium Earned Between Both Transactions: $0.98.

However, the order was placed on only ten (10) contracts so the commissions on the four-part deal were much higher than they would be on, say, 500 contracts. Thus, the actual net premium earned was substantially lower as trading costs cut into the profit, coming in at $0.73 per share - not $0.98 per share (more precisely, $734.14 for 10 contracts). The following analysis is based upon the $0.73 per share figures for that reason.

What This Trade Did - Summary

This type of trade, a Long Iron Condor, generates cash income if a stock stays within a predefined trading range. In the case of this particular transaction, the break-even range is $17.27 to $23.23 per share. That is, if the stock never left those areas, you would be no worse off than you had been before entering into the transaction. Anything above or below those figures will cause a maximum potential loss of between $0.77 and $1.27 per share no matter how high or low the stock price fluctuates.

Detailed Analysis

The biggest potential loss is the $2.00 spread on the puts (the calls only have a $1.50 spread). Subtracting out the $0.73 per share we made, it looks like the biggest potential loss on the downside is $1.27 and on the upside is $0.77.

Scenario 1: The Stock Trades In A Narrow Range

• If the stock trades between $18.00 per share and $22.50 per share, we get to keep the entire $0.73 per share net premium.

Scenario 2: The Stock Falls

• If the stock trades between $17.27 and $18.00 we will be between break-even and some profit.
• If the stock trades below $17.27 and $16.00 we lose money - $1.27 per share, to be exact, which is our maximum potential loss.
• If the stock trades below $16.00 we are still capped at our maximum potential loss of $1.27 because we own a $16 put that gives us the right to sell the stock at that price. If it were to fall to $8 per share, we could simply buy the stock then immediately exercise the put to recapture the difference. This is even true if the stock were to go to $0 per share.

Scenario 3: The Stock Rises

• If the stock trades between $22.50 and $23.23 we will be between break-even and some profit.
• If the stock trades between $23.23 and $24.00 we lose money but our losses are capped at a maximum loss of $0.76 per share.
• If the stock trades above $24.00 we are still capped at our maximum potential loss because we own a $24 call that gives us the right to buy the stock at that price, effectively limiting the $22.50 calls we sold.

Why This Trade Is Attractive Relative To Other Techniques

The major advantage of a Long Iron Condor trade is that it requires far less capital than alternative techniques. For instance, to generate $734.14 gain writing covered calls, an investor would need to purchase 420 shares of Wells Fargo common stock at the current market price of $19.61. This would require a net $7,502.06 in capital tied up either by reducing cash or tapping margin borrowing ($8,236.20 before commissions to purchase the stock less the $734.14 generated by writing the covered calls). Additionally, the investor is left with complete downside risk so the maximum theoretical loss in this case is $7,502.06. Of course, if the company is healthy, they could simply wait for the share price to recover or continue to write covered calls, constantly lowering their cost basis on the stock. That isn't possible in the Long Iron Condor; if the trade turns unprofitable, that's it - you start over with a new one because the options cease to exist upon expiration. With the Long Iron Condor, in contrast, you'd tie up virtually no money to generate the same potential maximum gain. You could instead use the $7,502.06 to invest in shares of long-term holdings, bonds, cash, or whatever else fit your portfolio needs.

There are other risks in a Long Iron Condor trade. If a stock fluctuates into an exercisable strike range during the period before expiration, it is possible for you to get "assigned". That is, the calls you write or the puts you sold could require you to sell stock you don't own in that moment or buy stock according to the put agreement before the Long Iron Condor trade works out on its own. In such a case, of course, you could simply turn around and restructure the trade at a small gain or loss depending upon the details. You have no control over when your options will get assigned - it's a random process organized by the options clearing house. Of course, this risk can be reduced (and the option income you earn lowered, obviously) by providing an even broader range for the Condor trade by selecting calls and puts that are even more out of the money. Our trade, for instance, was based upon $18 puts and $22.50 calls written. You could have instead opted for a lower put and a higher call.

The bottom line: If you believe that a stock will trade within a range and have a specific figure with which you are willing to speculate knowing precisely the maximum amount you could lose on one trade, a Long Iron Condor could allow you to earn the same profit without tying up much, if any, of your capital.