Condors and Iron Condors

Vertical spreads were one of the very first structures we examined because they're incredibly versatile, particularly when we replaced an individual option with a vertical spread such as in a call spread risk reversal or in a put spread collar as well as when we combined two similar vertical spreads to create a butterfly. But if we buy the wings and sell the body of an out-of-the-money butterfly, then the underlying stock has to move in order for the butterfly to be profitable and the maximum profit is only achieved if the underlying stock is precisely at the middle strike price at option expiration. If the stock is even a little above or a little below that middle strike price, then the profit realized is less than the maximum potential profit. Since a butterfly is really two vertical spreads that share a middle strike price, what happens if we use two vertical spreads in the same sort of general configuration but select vertical spreads that don't share a central strike price meaning that the range of maximum profit is wider? That would be a condor. A condor is a spread of two vertical spreads. In a long condor, we'll buy one vertical spread and sell another vertical spread; the spread we buy is an in-the-money vertical spread meaning both legs are in-the-money, while the spread we sell is an out-of-the money vertical spread in that both legs are out-of-the-money. Let's look at some call options on Apple (AAPL) and see how we might use them to construct a long call condor. Since some of these options are in-the-money and have wide bid/ask spreads we'll use the average of the bid price and ask price. We see these options in Figure 12.1.

This long call condor is long an in-the-money call vertical spread, the 410/440 call spread (long the 410 call, short the 440 call), which cost 24.52. Since we're long

Buying a Call Condor in Apple

FIGURE 12.1 Buying a Call Condor in Apple

this call vertical and since it is in-the-money we want AAPL to stay near its current price of 456.68, rally, or decline only slightly while staying above 440.00, because those three outcomes result in this call vertical spread achieving its maximum value of 30.00 at expiration. If any of those three outcomes occur, no movement at all, a rally or a small decline, then we'll realize the maximum potential profit of 5.48 because AAPL will be above 440.00 at option expiration and the call spread we paid 24.52 for will be worth 30.00 at expiration. But a call condor is also short an out-of-the-money call vertical spread, the 470/500 call spread in this case, for which we receive 5.65. Since we're short this 470/500 call vertical and since it's out-of-the-money we want AAPL to stay near its current price of 456.68, decline, or rally only slightly while staying below 470.00 so that this call vertical expires worthless which it will do as long as AAPL is below the 470 strike at expiration. The in-the-money vertical spread needs little movement or a rally, the out-of-the-money vertical needs little movement or the stock to fall. In the net, a long condor needs the stock to experience little movement, we need the underlying stock, AAPL in this case to exhibit little volatility.

A long condor, either call or put, is a limited risk, nondirectional trade that we'd execute when we expected little volatility. A condor is a spread of two vertical spreads. It's similar to a butterfly, which is also a spread of two vertical spreads, but a butterfly uses only three strike prices with the middle strike, called the body, being shared by the two vertical spreads. A condor splits the body and instead uses two different strike prices. In the case of our Apple call condor the body was split into the 440 and 470 strike calls. A long condor wants the stock to be between

Long the Apple +10/440/470/S00 Call Condor and the Constituent Vertical Spreads

FIGURE 12.2 Long the Apple +10/440/470/S00 Call Condor and the Constituent Vertical Spreads

the two vertical spreads, meaning between the two center strike prices, (440 and 470 in this example) at expiration. That's when it achieves its maximum profit because the long vertical will achieve its maximum value while the short vertical expires worthless. The two vertical spreads are usually the same width, measured as the distance between the strike prices, although changing the width of one spread slightly might align the condor with a particularly important point on the stock's chart.

The maximum risk for a long condor is the net premium paid, 18.87 for our September AAPL call condor. Let's look at the sort of payoff chart we're familiar with to see this and we'll chart the payoff as we should, as a combination of two call vertical spreads. We can see this in Figure 12.2.

Since Figure 12.2 shows both the component vertical spreads and the resulting condor it can be a little tough to figure out which is which. It's important to remember that a condor is a spread made up of two vertical spreads but let's look at just the condor for clarity's sake. See Figure 12.3, which also shows the important inflection points for this condor.

The cost of the condor is 18.87 so that's the maximum risk, the most the condor can lose. We'll realize that loss if the long call vertical, the lower vertical (the 410/440 call spread in this case) is worthless, meaning that all that we spent to buy it has been lost while the premium received for selling the short vertical, the upper vertical (the 470/500 call spread in this case), isn't enough to offset the loss. If the long call vertical expires worthless this AAPL call condor would lose 24.52

The AAPL Call Condor

FIGURE 12.3 The AAPL Call Condor

by buying the lower vertical spread, the 410/440 call spread, but we only make 5.65 for selling the upper vertical, the 470/500 call vertical. The net loss is 18.87 (24.52 — 5.65).

We'll also realize that maximum loss of 18.87 if the short vertical is worth its maximum value of 30.00 meaning that we only collected 5.65 to sell a call vertical spread that is now worth 30.00, but the gain from buying the lower vertical spread, the 410/440 call vertical spread, is only 5.48. In this case, we lose 24.35 selling the 470/500 call vertical spread and only make 5.48 (30.00 — 24.52) from buying the lower call vertical spread. The net loss again is 18.87 (24.35 — 5.48). We'll lose the maximum value if the underlying stock is below the lowest strike price or above the highest strike price at expiration.

But what's the maximum profit? The maximum profit is the maximum potential profit from the call vertical we've purchased plus the maximum potential profit from the call vertical we sold. This maximum potential profit will be realized when the lower call vertical spread, the 410/440 call vertical we've purchased, is worth its maximum value of 30.00 at expiration meaning we've made the maximum profit possible in being long it, while the upper call vertical spread, the one we've sold, the 470/500 call vertical, expires worthless meaning we've made the maximum potential profit from being short it. This maximum profit will be realized when the underlying stock is between the vertical spreads at expiration meaning the underlying stock is between the two short legs. You can see this in Table 12.1.

TABLE 12.1 Our AAPL Call Condor and the Important Potential Outcomes

Outcome

Result

Where Does This Occur?

Max profit

+ 11.13 (5.48 + 5.65)

Between 440.00 and 470.00

Max loss

-18.87 (24.54-5.65)

Below 410.00 or above 500.00

Breakeven (lower)

0.00 (-5.65 + 5.65)

428.87

Breakeven (upper)

0.00(5.48-5.48)

481.13

What are the likelihoods these outcomes will occur? What is the likelihood that the underlying stock will be between the two vertical spreads at expiration meaning that we'll realize the maximum profit? You can see these likelihoods in Table 12.2. We can use the tools at OptionMath.com to calculate these likelihoods since, as we know, these likelihoods are the option deltas.

Today's likelihood of the 440 strike call being in-the-money at expiration, given all the variables including time to expiration, current stock price, volatility, and so on is 65 percent. We want this 440 call to be in-the-money at expiration so that we realize the maximum value of the 410/440 call spread. Today's likelihood of the 470 strike call being in-the-money is 33 percent; we want this 470 call to be out-of-the-money at expiration so that we keep the premium received for selling the 470/500 call spread. That means the likelihood of AAPL being between the two strike prices at expiration, AAPL being above 440 but not above 470, is 32 percent (65 percent — 33 percent). The likelihood of realizing the maximum profit of 11.13 for this call condor is that 32 percent.

What is the likelihood of realizing the maximum loss? That's the likelihood that AAPL is above 500 plus the likelihood that AAPL is below 410 at option expiration because either outcome will result in the maximum loss. The delta of the 410 call is 88, so today's likelihood of AAPL being below there at option expiration is 12 percent. The delta of the 500 strike call is 12, so the odds of AAPL being above there at option expiration are also 12 percent. That means the likelihood of this AAPL call condor realizing its maximum loss of 18.87 is 24 percent (12 percent + 12 percent). And what are the odds of at least breaking even? The downside

TABLE 12.2 Important Likelihoods for Our APPL Call Condor

Call Option Strike Price

Call Option Delta

410

88

428.84 (lower breakeven)

74

440

65

470

33

481.13 (upper breakeven)

25

500

12

breakeven is 428.87; this is the point at which the loss from the long call spread is precisely offset by the profit from the short call spread. We can calculate the delta for this hypothetical 428.87 strike call using the tools at OptionMath.com, but it means that we'll have to “borrow” the volatility input from a nearby option. If we do that we determine that the delta of this hypothetical call option is 74. The odds of losing the maximum amount because AAPL dropped below 410 are 12 percent, the odds of losing any money at all because AAPL dropped too far, that is, because AAPL dropped below 428.87, is 26 percent.

The odds of losing the maximum amount because AAPL rallied too far are 12 percent, the odds of losing any money at all because AAPL rallied too far are 75 percent.

It's enough to say that a long condor can be a good strategy if you're looking for a defined risk way to profit from low realized volatility over the term of the options, although the maximum loss can be substantially more than the maximum profit.

We've looked at buying a call condor in AAPL. Condors work well with puts as well. Since long put condors are very similar to long call condors, we'll take a very quick look at a long put condor. Figure 12.4 shows some puts on AAPL that we might use to construct a put condor.

Again, we're going to buy an in-the-money vertical spread and sell an out-of-the-money vertical spread. In this case, the in-the-money vertical spread we are buying is the 470/500 put spread (buying the 500 strike put, selling the 470 strike put) and the out-of-the-money vertical spread we're selling is the 410/440 put spread (selling the 440 strike put, buying the 410 strike put). The 470/500 put spread cost 24.35, while we receive 6.45 for selling the 410/440 put spread. The total cost of

Buying a Put Condor in AAPL

FIGURE 12.4 Buying a Put Condor in AAPL

Outcome

Profit or Loss

Where Does It Occur?

Maximum profit

+ 12.10 (5.65 + 6.45)

Between 440.00 and 470.00

Maximum loss

-17.90(24.35-6.45)

Below 410.00 or above 500.00

Breakeven (lower)

0 (5.65 – 5.65)

427.90

Breakeven (upper)

0 (6.45 -6.45)

482.10

this put condor is 17.90. Notice that the vertical spreads have the same width, and they are about equidistant from where the stock is currently trading. And what is the maximum profit and loss for this Apple September 410/440/470/500 put condor? Where are those realized? We can see this in Table 12.3.

Let's connect the dots again and see the traditional payoff chart for this long put condor in AAPL.You can see this in Figure 12.5.

The general payoff for this put condor and the call condor that used the same strikes are very similar. Why aren't they identical? Because the underlying stock wasn't precisely between the two vertical spreads when we priced them. AAPL was at 456.68 so it was slightly closer to the 470/500 vertical. But the general shape of the two payoff charts is very similar, as we'd expect. So which condor to use? If the call condor is easier for you to understand, then use the call condor. If for some reason the bid/ask spread for in-the-money puts is tighter than for in-the-money calls, then use the put condor because it will be easier and cheaper to execute. We'll talk more about the bid/ask spread shortly.

A Long Put Condor in AAPL

FIGURE 12.5 A Long Put Condor in AAPL

 
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