Learn how to calculate the maximum risk when trading an iron condor.

Alright. Hey everyone. This is Kirk here again at Option Alpha and in this video, I want to go through iron condor risk calculations. And yes, there are going to be many risk calculations that we’re going to do in this video. We’re going to look at a balanced iron condor, as well as an unbalanced iron condor. And I really encourage you to take your time with this one because it’s really important you understand exactly how these iron condor positions work and how to effectively calculate the risk in these iron condors. The first thing we’re going to do is we’re going to start with a simple payoff diagram structure and we’re going to build out our iron condor position. We’re going to build a balanced iron condor first which looks like this. And by balanced, what I mean is that the long legs on either side or the spread width is exactly the same as you’ll see here in a second, and it carries the same risk on this side as it does on this side, meaning that the position is balanced and it doesn’t have an unbalanced association of risk. We will look at an example of that here in a little bit. But as always, the iron condor payoff diagram pivots at these four points. These are the points at which you either buy or sell different contracts to build out this payoff diagram, and what we’re concerned about is trying to figure out what these risk levels are, how much are we willing to risk or how much are we risking in our iron condor position when we build it out.

We’re going to do things a little bit different here to start calculating out the risk. I think this will help out in this video. As always, if you have any questions, let me know. The first thing that we’re going to do is we’re going to assume that the stock right now is trading somewhere in between here at $50 per share. And so, we’re building out this iron condor, hoping that the stock trades around that $50 price point, trying to capture some premium from selling options around there. The first thing that we have to do to build out our iron condor is we have to sell one put option at a lower strike price than where the stock is trading. We’re going to say –1P for put option and we’re going to put this put option at $40 as a strike. Then we also have to buy a put option, so we’re going to say +1P and we’re going to say that this particular strike is 35. On this side of the payoff diagram, we’ve got a $5 wide spread, the difference between selling the put option at 40 and buying it at 35. On the call side, we’re going to do the same thing, just in reverse with call options. In this case, we’re going to go ahead and sell one call option, so – 1C because we’re selling a call option and we’re going to sell this call option at a 60 strike. And then on the further out side, we’re going to buy another call option, so +1C at an even higher strike to create this call spread side of our iron condor payoff diagram and we’re going to start buying this one at 65. Now, again, this is a very balanced iron condor because not only do we have a pretty equal distance from the market on both sides, but also the spread width on both sides of the payoff diagram is the same. We’ve got a $5 wide spread here and a $5 wide spread here which makes the risk calculations not only just a little bit easier, but the risk on both sides is going to be exactly the same when we calculate the risk amount.

Now, what we have to do is we have to total up what the credits are that we collected from selling and buying all of these different contracts. I’ll do this over here on the sidebar, so you guys can see this, but let’s say that we sold the first put option at the 40 strike. We sold that contract for $2.10 and then we bought one put option at the 35 strike for $1.72. Now, in this case, we now know that this particular spread collected a net credit of $.38. That’s how much money we collected from selling this contract for $2.10 and then buying this contract for $1.72. We also had the call spread side. We sold the one call option at the 60 strike. Let’s say we sold that one for $2.38 and let's assume that we bought the one call option at the 65 strike for $1.12. And yes, I’m doing these deliberately a little bit more confusing than just a regular $1, $1.50 because I want you guys to actually go through this and understand exactly how it works. Go through it with your calculator on your phone or your computer right now, so you understand how this math works out. The call side spread still collected a credit, a nice credit actually of $1.26. Now, we can see the difference between buying and selling all of these contracts. On the put spread side was $.38 and on the call spread side was $1.26. If we add those two credits together, so the $.38 plus the $1.26, then we get a total credit that we collected on this iron condor of $1.64. Now, that ends up being the potential profit that we can make here which is $1.64 if the stock closes inside of our strike prices and inside of our range. That’s how much money we could potentially make on this position. Now, that’s great, but it doesn’t tell us how much money we can lose.

What we need to do when we calculate the risk on an iron condor is we need to first, take into account the width of the different wings. Now, in this case, because we deliberately did this, we made the width of the wings exactly the same on both sides, $5. If we take $5 as the width of the wings and we subtract the credit that we received in total which was $1.64, then what we’re left with is we’re left with the total risk on this position should the stock go outside of these boundaries and get towards our defined risk levels above 65 or below 35. Our total risk is the width of the wings which is $5, less the credit received which is $1.64, and that gives us a total risk of $3.36 for every iron condor that we get into. That is how much we could potentially lose, $3.36 on either side if the market goes either direction. Now, a lot of people look at this and they say, “Well, wait. I could lose potentially more than $3.36?” No, because the market can’t be in two places at one time. Either the stock goes up and closes above 65 or it goes down and it closes below 35. If either of those two things happen, then you lose the most amount in the position which is $3.36 before any adjustments. Now, if you want to do some very quick math and just double check yourself, you can take the $3.36, you add that to your profit calculation, and that should equal the width of the spread which is $5. If it doesn’t equal that, then you’ve done something wrong and you need to redo your calculations.

Now, as great as this is right now, this is a very simple structure for this iron condor position, and so, what we want to do now is we actually want to change this up just a little bit and we want to do an unbalanced iron condor. And when you do an unbalanced iron condor, the calculation framework is roughly the same, but you’re going to have to think about it just a little bit different. In this case, what we’re going to do is we’re going to recalculate this position now with an unbalanced iron condor instead of a balanced or neutral, symmetric iron condor. In this case, what we’re going to do is we’re not going to buy the call options at the 65 strike any more like we did before. We’re actually going to buy the call options at the 66 strike, and what that does is that pushes our payoff diagram lower. Now, we’re going to buy one call at the 66 strike and in this case, we’re going to buy this call option here for $.80. We’ll do these calculations again, so you can see how it works, but notice that this is now an unbalanced or uneven iron condor. You have now $6 of potential spread width on this side and you still have your $5 spread width here. It makes the calculations just a little bit different, but again, the framework is the same. First thing that we’re going to do is we’re going to calculate the put side, so we’ll go through this all over again. We sold one put option at a 40 strike. We again, sold that for $2.10. We bought one put option at the 35 strike and we bought that for $1.72. That still gives us a total credit on the put spread side of $.38 for this particular position. On the call spread side, we still sold the same one call option at the 60 strike here. We still sold that for $2.38, but now, we bought instead of the 65 call, we bought the 66 strike call option. Now, the 66 strike call option is clearly cheaper than the 65 where it should be in most markets, and so, we only paid for the 66 call option now $.80.

Now, by the way, this is not a bad thing to do. And you can definitely make your iron condors or your iron butterflies that you start building uneven and unbalanced like this. It’s not a bad thing to do. It’s just understanding the dynamics of how it changes the risk on one side or the other of the payoff diagram. In this case, the net credit that we collected now on the call spread side is $1.58. The total credit that we collected now on the whole position… Because we did increase the width of the spread and this call option was a little bit cheaper, we now collected a total premium of $1.96. Now, that’s great. That means that if the stock stays in between our range that we’re looking for, our total profit here is $1.96. We’ve actually increased the total profit in this position by widening out this particular leg of the spread. However, now what we have to do is we have to calculate how much risk is inherent in this iron condor. Now, this is going to be a little bit of a two-part calculation here. Now, we have uneven sides, so we have to calculate the risk that the iron condor goes lower or basically, what we’ll call like risk calculation number one, and we have to calculate the risk if the iron condor goes higher, what we’re going to call risk calculation number two. Basically, R1 or risk number one is the width of the spread which we’ve done before which is $5, less the credit received which is $1.96, and that gives us a total risk on the put spread side of $3.04. We can just put that in here, that we’re risking $3.04 on this side. To calculate the other risk side which is risk two, we’re going to say R2 is equal to the width of the spread, same thing that we did here, but now, our spread width is a little bit wider. Instead of $5 like it was before, now our spread width is $6 and we still subtract the same credit that we collected of $1.96, and that gives us total risk on the call spread side of $4.04.

At this point now, we have our total risk on both sides of this iron condor position. And this is why it’s a little bit confusing because if somebody asked you what’s your risk on this particular iron condor or if you’re trying to calculate out your position sizing on an iron condor and it has uneven legs or uneven wings, then you’re going to end up with two different numbers that you could potentially calculate, the risk on one side which is more narrow and the risk on the other side which is a little bit wider. Again, what you can always do just to double check your math, is you take the total risk that you calculated, add that to the total profit potential, and on each individual side, that should still add up to the width of the wings. In this case, $3.04 plus $1.96 is equal to $5 which is in fact, the width of the wings. On this side, $1.96 plus $4.04 is equal to $6 which is the width of this particular side of the position and wing. Now, one quick tip on iron condor risk – If you are calculating iron condor risk like we suggested here and using it for the basis of calculating position size or allocation percentage, we absolutely suggest that you use the wider of the two amounts always to be more conservative. In our case, even though we could lose less money if the stock goes lower and starts to breach our strike prices on the bottom side, we will always base our risk calculations and our percentages based on the higher amount of the two. If we had a wider spread on the put spread side, we would base it on whatever is the highest risk calculation amount on either side, and that way, you just become very conservative with your position sizing and your portfolio management. Hopefully this video has helped out. As always, if you have any questions, let us know and until next time, happy trading.

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