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How to Collect Premium with Iron Condors

December 30, 2010 by Nick Metzger| Tips & Strategies

Iron Condor with Chart
Different circumstances call for different trading strategies.  Part of becoming a complete trader is a balanced, disciplined approach with an eye geared towards managing risk.  You can accomplish this by trading futures, options, or a combination of the two.  The difficult part is determining which approach will be the best for you, and this formula might be different for every trader.  In this article, my intention is to open your eyes to a more unique trading approach, collecting premium with Iron Condors.

I’ve heard a lot of myths and confusion in regard to iron condors, so I’m attempting to break this down for you in simple, easy to understand language.  In order to accomplish this, we need to have a basic understanding of credit spreads.

Understanding Credit Spreads

A credit spread is when you sell a closer to the money (more expensive option) and purchase a cheaper (further out of the money option) on the same underlying commodity at the same expiration.

Let’s take a look at an example using gold futures;

Gold futures    = 1400
1350 puts    = $3500
1300 puts    = $1500

Gold futures are trading at 1400 and we feel bullish on this market.  We could sell a 1350 put and purchase a 1300 put.  The premium in the 1350 put is going to be higher than the 1300 put because it is closer to where the market is currently trading.  We would collect the $3500 premium from the 1350 put and pay out the $1500 premium of the 1300 put at a net credit on the trade of $2000.  Our defined profit is the amount we collected between the 1350/1300 put spread, $3500 – $1500 = $2000.  We’re risking the difference between our two strike prices, (1350 – 1300 = 50 x $100/point = $5000.  And, since we already collected a premium of $2000, our defined risk is reduced to $3000 ($5000 – $2000 = $3000).

So… What is an Iron Condor?

An Iron Condor is simply a combination or two vertical spreads.  To create the iron condor, we would sell both a call spread and a put spread.  The idea behind this is to take advantage of a sideways market and allow us to design a strategy based on where we feel the market will NOT go.

How to Use an Iron Condor Strategy

Once again, let’s take a look at an example using gold futures.

The current price of gold is 1400.  We feel that the market will likely trade within a channel between 1350 and 1500 over the next 30-60 days.  Gold options are currently trading at the following prices:

1500 call    = $3500
1550 call    = $1500
1350 put    = $3500
1300 put    = $1500

In order to take advantage of a sideways market we would use an iron condor by selling the 1500/1550 call spread and the 1350/1300 put spread.

How to Calculate the Profit Potential

Long Iron Condor Strategy
We would place an order to sell the 1500 call and purchase the 1550 call.  We would collect $2000 premium on our call spread ($3500 – $1500 = $2000).  We would also sell the 1350 put and purchase the 1300 put.  We would collect another $2000 premium on our put spread ($3500 – $1500 = $2000).  This would define our profit potential to $4000 (total premium from call spread + put spread, $2000 + $2000 = $4000).

Maximum Profit Potential = Call Spread Premium + Put Spread Premium

How to Calculate the Defined Risk

We can also use these numbers to calculate our defined risk.  Our defined risk is the difference between our spread strike prices minus the amount we collected.  Since we have both a put and call spread, we know our risk is limited to only one side.  The market cannot expire above our call spread and below our put spread simultaneously, so we have a risk of just $5000 (1350 – 1300 = 50 x $100/point = $5000 or 1500 – 1550 = 50 x $100/point = $5000).  Note: If the difference between our strike prices were not balanced, we would use the greater difference.  However, this is before we take into account the premium we collected.  We have collected a total of $4000 for our put and call spreads upfront, so we can deduct this from our risk total.  Thus, our defined risk would be reduced to $1000 ($5000 – $4000 = $1000).

Defined Risk = Greater Difference between Strike Prices – Premium Collected

Benefits of an Iron Condor Trading Strategy

Now that we understand what an Iron Condor is, we need to understand why we would want to use this trading strategy.  Buying options are great in regard to their risk reward.  You can define your risk to a very small sum, while having unlimited profit potential.  The downside of this strategy is the probability.  The majority of cheap, far out of the money options will expire worthless.  So although you are only risking a few hundred dollars on each option, the odds of these being profitable are low.

That being said, if the majority of options are going to expire worthless, then why don’t we just sell options? You can, but you are running the risk of that one cheap option turning into a very valuable option.  So you might have a defined profit a few hundred dollars with unlimited risk.

This is why the Iron Condor is an attractive strategy.  You are doing your part managing your risk because you know what the worst outcome can be.  You are also keeping the odds in your favor.  We know that the majority of all out of the money options are going to expire worthless, so we should have more profitable trades than losing trades.

In conclusion, an Iron Condor can be a simple strategy.  It is a combination of two credit spreads: one to the call side and one to the put side.  This allows you to take advantage of sideways markets and to design a strategy based on where you feel the market will NOT go.  This strategy allows you to define your risk, while keeping the odds in your favor, and providing you with a flexible and disciplined approach to the markets.

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Filed Under: Tips & Strategies

About Nick Metzger

Nick Metzger serves as a Senior Broker with Daniels Trading. Nick earned his B.A. in finance and economics from Northwood University. Along with his success in the classroom, Nick excelled on the baseball field as a 4-year starter and team captain. Upon graduation, Nick carried his determination on the field to the financial markets. He began his career with a firm that specialized in option trading where he learned how to evaluate market fundamentals with a technical overlay for timing trades.

Craving employment with a firm offering more diverse execution services, Nick relocated to Chicago and joined Daniels Trading. Since joining Daniels Trading Nick has broadened his execution offerings. He now prides himself in matching clients assets with a wide array of trading opportunities including, broker execution, online trading, automated trading systems, and managed futures.

Risk Disclosure

WHEN INVESTING IN THE PURCHASING OF OPTIONS, YOU MAY LOSE ALL OF THE MONEY YOU INVESTED.

WHEN SELLING OPTIONS, YOU MAY LOSE MORE THAN THE FUNDS YOU INVESTED.

STRATEGIES USING COMBINATIONS OF POSITIONS, SUCH AS SPREAD AND STRADDLE POSITIONS MAY BE AS RISKY AS TAKING A SIMPLE LONG OR SHORT POSITION.

THIS MATERIAL IS CONVEYED AS A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION.

THIS MATERIAL HAS BEEN PREPARED BY A DANIELS TRADING BROKER WHO PROVIDES RESEARCH MARKET COMMENTARY AND TRADE RECOMMENDATIONS AS PART OF HIS OR HER SOLICITATION FOR ACCOUNTS AND SOLICITATION FOR TRADES; HOWEVER, DANIELS TRADING DOES NOT MAINTAIN A RESEARCH DEPARTMENT AS DEFINED IN CFTC RULE 1.71. DANIELS TRADING, ITS PRINCIPALS, BROKERS AND EMPLOYEES MAY TRADE IN DERIVATIVES FOR THEIR OWN ACCOUNTS OR FOR THE ACCOUNTS OF OTHERS. DUE TO VARIOUS FACTORS (SUCH AS RISK TOLERANCE, MARGIN REQUIREMENTS, TRADING OBJECTIVES, SHORT TERM VS. LONG TERM STRATEGIES, TECHNICAL VS. FUNDAMENTAL MARKET ANALYSIS, AND OTHER FACTORS) SUCH TRADING MAY RESULT IN THE INITIATION OR LIQUIDATION OF POSITIONS THAT ARE DIFFERENT FROM OR CONTRARY TO THE OPINIONS AND RECOMMENDATIONS CONTAINED THEREIN.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING FUTURES CONTRACTS OR COMMODITY OPTIONS CAN BE SUBSTANTIAL, AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING LEVERAGED POSITIONS AND MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS AND FOR THEIR RESULTS.

TRADE RECOMMENDATIONS AND PROFIT/LOSS CALCULATIONS MAY NOT INCLUDE COMMISSIONS AND FEES. PLEASE CONSULT YOUR BROKER FOR DETAILS BASED ON YOUR TRADING ARRANGEMENT AND COMMISSION SETUP.

YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUMSTANCES AND FINANCIAL RESOURCES. YOU SHOULD READ THE "RISK DISCLOSURE" WEBPAGE ACCESSED AT WWW.DANIELSTRADING.COM AT THE BOTTOM OF THE HOMEPAGE. DANIELS TRADING IS NOT AFFILIATED WITH NOR DOES IT ENDORSE ANY TRADING SYSTEM, NEWSLETTER OR OTHER SIMILAR SERVICE. DANIELS TRADING DOES NOT GUARANTEE OR VERIFY ANY PERFORMANCE CLAIMS MADE BY SUCH SYSTEMS OR SERVICE.

GLOBAL ASSET ADVISORS, LLC (“GAA”) (DBA: DANIELS TRADING, TOP THIRD AG MARKETING AND FUTURES ONLINE) IS AN INTRODUCING BROKER TO GAIN CAPITAL GROUP, LLC (GCG) A FUTURES COMMISSION MERCHANT AND RETAIL FOREIGN EXCHANGE DEALER. GAA AND GCG ARE WHOLLY OWNED SUBSIDIARIES OF STONEX GROUP INC. (NASDAQ:SNEX) THE ULTIMATE PARENT COMPANY.

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Risk Disclosure

THIS MATERIAL IS CONVEYED AS A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION.

THIS MATERIAL HAS BEEN PREPARED BY A DANIELS TRADING BROKER WHO PROVIDES RESEARCH MARKET COMMENTARY AND TRADE RECOMMENDATIONS AS PART OF HIS OR HER SOLICITATION FOR ACCOUNTS AND SOLICITATION FOR TRADES; HOWEVER, DANIELS TRADING DOES NOT MAINTAIN A RESEARCH DEPARTMENT AS DEFINED IN CFTC RULE 1.71. DANIELS TRADING, ITS PRINCIPALS, BROKERS AND EMPLOYEES MAY TRADE IN DERIVATIVES FOR THEIR OWN ACCOUNTS OR FOR THE ACCOUNTS OF OTHERS. DUE TO VARIOUS FACTORS (SUCH AS RISK TOLERANCE, MARGIN REQUIREMENTS, TRADING OBJECTIVES, SHORT TERM VS. LONG TERM STRATEGIES, TECHNICAL VS. FUNDAMENTAL MARKET ANALYSIS, AND OTHER FACTORS) SUCH TRADING MAY RESULT IN THE INITIATION OR LIQUIDATION OF POSITIONS THAT ARE DIFFERENT FROM OR CONTRARY TO THE OPINIONS AND RECOMMENDATIONS CONTAINED THEREIN.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING FUTURES CONTRACTS OR COMMODITY OPTIONS CAN BE SUBSTANTIAL, AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING LEVERAGED POSITIONS AND MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS AND FOR THEIR RESULTS.

TRADE RECOMMENDATIONS AND PROFIT/LOSS CALCULATIONS MAY NOT INCLUDE COMMISSIONS AND FEES. PLEASE CONSULT YOUR BROKER FOR DETAILS BASED ON YOUR TRADING ARRANGEMENT AND COMMISSION SETUP.

YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUMSTANCES AND FINANCIAL RESOURCES. YOU SHOULD READ THE "RISK DISCLOSURE" WEBPAGE ACCESSED AT WWW.DANIELSTRADING.COM AT THE BOTTOM OF THE HOMEPAGE. DANIELS TRADING IS NOT AFFILIATED WITH NOR DOES IT ENDORSE ANY TRADING SYSTEM, NEWSLETTER OR OTHER SIMILAR SERVICE. DANIELS TRADING DOES NOT GUARANTEE OR VERIFY ANY PERFORMANCE CLAIMS MADE BY SUCH SYSTEMS OR SERVICE.

GLOBAL ASSET ADVISORS, LLC (“GAA”) (DBA: DANIELS TRADING, TOP THIRD AG MARKETING AND FUTURES ONLINE) IS AN INTRODUCING BROKER TO GAIN CAPITAL GROUP, LLC (GCG) A FUTURES COMMISSION MERCHANT AND RETAIL FOREIGN EXCHANGE DEALER. GAA AND GCG ARE WHOLLY OWNED SUBSIDIARIES OF STONEX GROUP INC. (NASDAQ:SNEX) THE ULTIMATE PARENT COMPANY.

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