Iron condor is an option strategy with limited risk and limited profit potential. This page explains the calculation of its maximum loss and maximum profit (and explains how they relate to iron condor break-even points).
Iron Condor Max Loss Calculation
Maximum possible loss from an iron condor (or iron butterfly) position depends on only two things:
- Initial cash flow (net premium received)
- Wing width (distances between the wing strikes)
How Initial Cash Flow Affects Max Loss
Initial cash flow – net premium received when opening an iron condor position – does quite unsurprisingly affect total profit or loss.
The more cash you receive when entering the trade, the smaller your total loss if the trade goes against you, other things being equal.
Therefore, we can expect initial cash flow to be included in the max loss formula with a minus sign.
How Wing Width Affects Max Loss
Wing width may be less obvious. It is the distance between the two call strikes or the distance between the two put strikes (both distances should be the same, unless you have a broken wing iron condor).
For example, the wing width of a 45/50/60/65 iron condor is $5 (distance between the two call strikes is 65-60 and distance between the put strikes is 50-45).
The wing width decides how much one of the short options (the short call or the short put) can get in the money before its loss starts to be offset by the corresponding long option (the long call or the long put, respectively).
If underlying price ends up above the short call strike, the call is in the money. Because you are short, the further in the money it gets, the more you lose. But when underlying price reaches the long call strike, further losses are exactly offset by gains from exercising the long call. Therefore, the most you can lose at expiration is the difference between the two call strikes. Everywhere above the long call strike the total loss is constant.
It is similar on the put side. The most you can lose at expiration is when underlying price ends up at or below the long put strike. The loss equals the difference between the two put strikes. It does not grow any further below the long put strike.
Iron Condor Max Loss Formula
When we combine the maximum loss at expiration (distance between the wing strikes) with the initial cash flow (which is positive and reduces maximum loss), we get the iron condor max loss formula:
Iron condor max loss = wing width – initial cash flow
Note: This formula calculates max loss with positive sign (as max amount lost). If we want max loss as minimum (worst, most negative) P/L, it is initial cash flow minus wing width.
Broken Wing Iron Condor Max Loss Formula
We can generalize the formula to also apply to broken wing iron condor, where the two wings have different widths. Because maximum loss occurs on the wider wing side (bigger difference between the short and long strike), the max loss formula is:
Broken wing iron condor max loss = the greater of the two wing widths – initial cash flow
Iron Condor Max Profit Calculation
Maximum profit is very simple. The best case scenario with iron condor is that underlying price stays between the short (inner) strikes, all options are out of the money, and they just expire. There is zero gain or loss at expiration. Total profit from the iron condor trade equals initial cash flow (net premium received when entering the position).
Iron condor max profit = initial cash flow
Let's say we opened an iron condor with strikes 45 (long put) /50 (short put) /60 (short call) /65 (long call).
Initial cash flow (premium received for the short call and short put, minus premium paid for the long call and long put) is $2 per share.
This is also the most we can gain from the trade if underlying price stays between 50 and 60 at expiration. Maximum profit is $2.
What is the maximum loss?
Wing width (distance between the call strikes or between the put strikes – both the same), is 65-60 or 50-45, which is $5.
Maximum possible loss is wing width minus initial cash flow: 5 – 2 = $3 per share.
How Iron Condor Max Loss and Max Profit Relate to Break-Evens
The break-even points in our example are at $48 and $62. Between these two prices we profit, outside we lose.
Notice how the distance of break-even points from the short strikes (62-60 and 50-48) equals initial cash-flow and their distance from the long strikes (48-45 and 65-62) equals maximum loss.
Think why this relationship holds.
Hint: Imagine how the underlying price gradually increases from the short call strike at $60 (maximum profit $2) to the long call strike at $65 (maximum loss $3).
Because the relationship between underlying price and payoff at expiration is linear (the payoff diagram is always a straight line), the break-even price (the point where the straight P/L line crosses zero on the way from +2 to -3) must be 2 pieces from the start (from $60) and 3 pieces from the end (from $65). It must be at $62.
It works the same on the put side (only with the underlying price declining from $50 to $45).