The Bid/Ask Spread and Condor Spreads

In buying a condor we said that we were essentially agnostic as to whether we establish our condor using puts or calls with one caveat. If calls or puts that are in-the-money show particularly tight bid/ask spreads then we generally want to use that type of option to establish our condor. It would be unusual for in-the-money puts to offer good (i.e., tight) bid/ask spreads and in-the-money calls to have wide bid/ask spreads but it's possible; usually, both will have bid/ask spreads that are tight or wide with tight being the exception if the option is in-the-money. But what general impact might the bid/ask spread have on our condor? After all, we're trying to execute four different options and we'll certainly try to execute our condor as a single trade minimizing the impact of the bid/ask spread but we'll still have to pay a liquidity provider something in the form of a bid/ask spread. Let's return to our very first condor and remember that the single price we saw for each option was, for simplicity's sake, the average of the bid and ask for each option. Table 12.5 shows the bid and ask for each component of that first condor that we bought, the AAPL 410/440/470/500 call condor, to see how the bid/ask spread might impact our condor.

If we were to simply pay the ask price for the options we need to buy and collect the bid price for the options we need to sell, we would pay 19.50 for this AAPL call condor rather than the 18.87 we assumed earlier. We'd pay 0.63 more, driving our maximum profit from 11.13 to 10.50 without any change in how or where that maximum profit is achieved. Given that we'd hope to execute our condor at those midpoints we originally used but that we'd have to give up something to get our trade done, after all, market makers aren't in business to facilitate our trade without making any profit for themselves, it's very likely that our actual execution price, the price we actually pay, is going to be higher than 18.87. Is there a way to reduce the impact of the bid/ask spread on the in-the-money call vertical spread? If we look at the four options making

TABLE 12.5 Bid and Ask Prices for Our AAPL Call Condor

Option

Bid

Ask

September 410 call

46.70

47.30

September 440 call

22.25

22.70

September 470 call

7.85

8.00

September 500 call

2.26

2.30

An Iron Condor in AAPL

FIGURE 12.8 An Iron Condor in AAPL

up our call condor we'll notice that the out-of-the-money options, the 470 call and 500 call, have narrower bid/ask spreads than the in-the-money options, the 410 call and 440 call. Is there a way to replace that portion of our condor, the in-the-money 410/440 call spread, with something that's out-of-the-money and has bid/ask spreads similar to the bid/ask spreads of these other out-of-the-money options? What if instead of buying that 410/440 call spread we sold the 410/440 put spread meaning that we sold the 440 put and bought the 410 call? Figure 12.8 shows what that would look like.

The maximum profit for this trade would be the total of 12.10 received, 5.65 for selling the out-of-the-money call spread and 6.45 for selling the out-of-the-money put spread and would be realized if both vertical spreads expired worthless meaning AAPL was between 440 and 470 at option expiration, the same range of underlying prices that yielded the maximum profit for our original call condor. That maximum profit of 12.10 is not very different from the maximum profit of 11.13 for the first condor we looked at.

The maximum loss for this trade would be 17.90, the 30.00 maximum value of both spreads less the 12.10 received. We would experience that maximum loss if either of those vertical spreads was fully in-the-money at expiration. That means AAPL would have to be below 410 or above 500 at expiration for this trade to realize its maximum loss. It's interesting that this is the same range that would result in the maximum potential loss for our call condor. This maximum potential loss of 17.90 is not that much different than the maximum potential loss of 18.87 for our call condor spread.

And how would the bid/ask spread impact this new trade? Let's take a look at the bid/ask spreads for all of the options in this new trade.

TABLE 12.6 Bid and Ask Prices for Our New Option Structure in AAPL

Option

Bid

Ask

September 410 put

2.13

2.27

September 440 put

8.55

8.75

September 470 call

7.85

8.00

September 500 call

2.26

2.30

While we initially assumed we executed this trade at 12.10, even if we sold every option that we had to sell, the 440 put and 470 call, at the bid and simultaneously bought every option we have to buy, the 410 put and S00 call, at the ask, we'd execute our trade at 11.83 (6.28 + 5.55). That's only a 0.27 penalty charged by the width of the market rather than the 0.63 penalty we might have paid for our original condor. What is this new, magical structure called? It's an iron condor.

 
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