How To Calculate The Risk-To-Reward Ratio Of An Iron Condor

By the top of this text, you’ll know the way to calculate the risk-to-reward ratio of an iron condor and the way to management this ratio.

Let’s have a look at an instance.

Contents

SPY is the S&P 500 ETF, which many would agree is probably the most liquid underlying within the equities world.

Let’s have a look at the SPY iron condor comprising a name and put credit score unfold.

Date: September 6, 2024

Worth: SPY @ $540

Purchase one October 31 SPY $590 name @ $0.45Sell one October 31 SPY $580 name @ $1.10Sell one October 31 SPY $500 put @ $4.67Buy one October 31 SPY $490 put @ $3.65

If an investor initiated the iron condor at these costs, he would obtain a $1.67 credit score per share.

As a result of:

$1.10 + $4.67 – $0.45 – $4.90 = $1.67

This iron condor has broad wings.

The put credit score unfold has a width of 10 factors (500 – 490).

The name credit score unfold additionally has a width of 10 factors (590 – 580).

The expiration graph of this iron condor modeled in OptionStrat would seem like this:

If the worth falls contained in the iron condor at expiration, the investor retains the credit score, and each the put unfold and the decision unfold expire nugatory out-of-the-money.

Therefore, the utmost revenue is $1.67 per share.

It is a single-contract iron condor.

Since one contract represents 100 shares, the utmost greenback revenue from this commerce can be $167.

Within the excessive case the place the worth strikes fully out of the iron condor on the draw back, the decision unfold will expire out-of-the-money nugatory, and the put unfold shall be at a whole loss.

As a result of the distinction between the quick and lengthy strikes is $10, the unfold shall be at a $10 loss per share.

Since $1.67 was collected as a credit score initially.

The precise max loss is $10 – $1.67, or $8.33.

Following the identical line of thought, the utmost loss can also be $8.33. on the upside, if the worth pierces the decision unfold.

The danger-to-reward ratio of an iron condor is the utmost threat divided by the utmost reward.

In our instance, that is calculated by taking the danger of $8.33 per share and divided by the max reward of $1.67.

Threat-to-reward ratio = $8.33 / $1.67 = 5

If you happen to choose to calculate it utilizing the full greenback threat of the commerce ($833) and the full greenback reward on a contract foundation ($167), you get the identical reply:

$833 / $167 = 5

If you happen to look again on the OptionStrat screenshot, these are the numbers that the modeling software program gives:

Max loss: $832.50

Internet credit score: $167.50

They match what we had calculated.

How Does The Threat-To-Reward Change If We Slender The Width Of The Spreads In The Iron Condor?

Generally, you might be lowering the danger by narrowing the width of the spreads.

Due to this fact, it will lower the risk-to-reward ratio.

The good thing about utilizing modeling software program is that we are able to merely change the strikes of the iron condor to be 5 factors broad as an alternative of 10:

Entry 9 Free Choice Books

Right here, it says that the max loss is $404 whereas the max reward is $96.

Due to this fact, this iron condor with slender wings has a risk-to-reward ratio of 4.2.

Calculated by 404 / 96 = 4.2

How Does The Threat-To-Reward Change If We Transfer The Spreads Nearer To The Cash?

Right here, we stored the width of the spreads at 5 factors however moved them nearer along with the quick strikes at $515 and $565:

We see that now the risk-to-reward is:

$285 / $215 = 1.3

Transferring the spreads nearer, we accumulate bigger credit score, leading to a bigger potential reward. Due to this fact, it decreases the risk-to-reward ratio.

What Is The Distinction Between  Threat-To-Reward Ratio And  Reward-To-Threat Ratio?

The danger-to-reward ratio is the danger divided by reward – as now we have been doing in our examples.

Threat-to-reward ratio = $833 / $167 = 5

Typically, folks will point out the reward-to-risk ratio, which is the reward divided by the danger. In our instance, it will be:

reward-to-risk ratio =  $167 / $833 = 0.2

One is the inverse of the opposite.

For instance:

1 / 5 = 0.2

And,

1 / 0.2 = 5

Typically, folks will use the 2 phrases loosely as an alternative of its strict definition.

So, it is very important know which quantity they’re speaking about.

What Is The Threat-To-Reward If We Gather One-Third Of The Width Of The Unfold?

The one that asks this query should be watching Tastylive, as they all the time point out that they like to gather one-third the width of the unfold in an iron condor.

Right here is an instance the place we accumulate $1.67 per share, and the width of the spreads is 5 factors:

As a result of:

1.67 / 5 = 0.33

We now have collected one-third of the width of the unfold.

Studying the numbers from OptionStrat, the risk-to-reward is:

$333 / $167 = 2

A risk-to-reward of two signifies that the max loss is twice the dimensions of the max potential revenue.

Is The Threat-To-Reward All the time Two If We Gather One-Third Of The Width Of The Unfold?

Sure, it’s.

Since:

reward = 1/3 * width

Then:

Threat / reward = (width – reward) / reward =  (width – 1/3 * width)  / (1/3 * width) = (2 / 3 * width) / (1 / 3 * width) = 2

So now we all know that Tastylive likes to have a risk-to-reward ratio of two to 1 for iron condors.

However you possibly can regulate the risk-to-reward to your liking.

Your reward is predicated on the credit score collected.

Your threat is predicated on the width of the unfold.

You’ll be able to slender the spreads to lower threat by lowering the risk-to-reward ratio.

Or you possibly can transfer the unfold nearer to the cash to gather extra credit score.

We hope you loved this text on the way to calculate the risk-to-reward ratio of an iron condor.

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Disclaimer: The data above is for academic functions solely and shouldn’t be handled as funding recommendation. The technique introduced wouldn’t be appropriate for traders who should not acquainted with alternate traded choices. Any readers on this technique ought to do their very own analysis and search recommendation from a licensed monetary adviser.