Anyone can make money in a bull market, and most people lose money in bear markets. But when markets are flat, it can be tough for investors to know what to do. Thanks to an options strategy known as the iron condor, though, there is a way for you to make money even when stock markets don't move much. Let's take a closer look at the iron condor and how you can use it to boost your profits.
Why so few people know the iron condor strategy
Many investors never look at strategies involving options, judging them to be too risky. Yet a strategy like the iron condor can help you control or even reduce risk.
The basic idea behind the iron condor strategy is very simple. By using a combination of different options contracts, the iron condor goes up in value over time if the price of the underlying stock stays within a certain range that you can define, producing a profit when the options expire. If the stock price moves outside that range, though, then the value of the position falls, and you'll suffer a loss to close out the position.
The implementation of the iron condor, though, is anything but simple. To use the iron condor, you have to buy or sell four different options contracts. The four contracts make up what are known as a call spread and a put spread, with two designed to produce your potential profit and the other two intended to limit your downside risk.
An example might help to make the iron condor clearer. Say a stock trades at $100 per share, and you think it will stay in a range between $90 and $110. The first step of the iron condor is to sell two options: a put option with a strike price of $90, and a call option with a strike price of $110. If the stock price at expiration is within the desired range, then you'd pocket the entire sales proceeds from those options.
The problem, though, is that you have potentially unlimited risk if the stock climbs above the $110 upper limit. To eliminate that risk, the iron condor has you buy two options that will offset the potential losses from the sold options. For instance, you could buy a put option with a strike price of $80 and a call option with a strike price of $120. That would limit your maximum loss to $10 per share, minus whatever net proceeds you received from the sale of the two options after paying for the two options you bought.
What to keep in mind with the iron condor
The iron condor definitely has the ability to produce profits in flat markets, but it comes with risks. It's crucial that you use the iron condor with stocks that have a lot of trading activity in options. Otherwise, it can be a nightmare to try to open four options positions in the same stock at the same time without seeing major price disparities that can take away much of your potential profit. For many stocks, underlying options markets are illiquid, with bid-ask spreads eating into your gains and allowing market-makers to capture much of your possible upside.
Also, as is always the case when you sell options, there's always the possibility that the person who buys the option from you will choose to exercise it. At that point, you'll either need to purchase replacement shares (if it was the call option that got exercised) or sell the shares that you received (if it was the put option). You'll want to monitor your account closely to make sure that you don't take on any risk that you weren't aware of -- and to make sure you're not holding onto shares of which you never intended to take possession.
The iron condor strategy sounds complicated, but it's fairly simple from a conceptual standpoint. By letting you define maximum profit and loss, the iron condor is a great way to profit from one of the most challenging market conditions investors ever have to face: a market that refuses to go anywhere.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.