Short Condor : Profit From Increased Volatility

Introduction To Short Condor

Short Condor

A short condor is an options trading strategy named after one of the largest flying birds in the Western Hemisphere. The condor is actually a flying vulture. And the reason why it is named that way is because its risk and reward profile resembles a condor with wings outstretched.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Anticipate Increased Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited potential loss
Step 7 : Maximum loss calculation
Step 8 : Limited potential profit
Step 9 : Maximum profit calculation for a short condor
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing A Short Condor
Step 12 : Exit Trade & Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

Conduct some research on the economic landscape and the underlying security. Foresee events that may cause an increase in the volatility of the underlying security. The catalysts may come in the form of an earnings announcement, a launch of a new product or a cut in its dividend payout due to a company’s debt restructuring plans.

A trader can also lookout for certain chart patterns forming as shown below. As long as prices move up and down and do not stagnate, the trader will tend to make a profit.

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 : Outlook – Anticipate Increased Volatility

The trader who executes a short condor is projecting increases in volatility of the underlying security moving forward. If the price of the underlying security stagnates, the trader stands to make a loss.

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Step 3 :Study the option chain

Examine the options chain and select the options to be used in the condor.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

Next, once the options have been selected, the options trader can find out where the breakeven points are.

There is an upside breakeven price point and a downside breakeven price point for a short condor strategy. At these points, there is neither profit nor loss.

The downside breakeven price point can be calculated as :

Net credit received + lowest strike price

The upside/higher breakeven price point can be calculated as:

Greatest strike price – net credit received

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Step 5: Understand Your Profit Zones

Short Condor

After the breakeven points has been calculated, the trader will know where the profit zones are. The profit zones are outside of the breakeven points for a short condor.

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Step 6 : Limited potential loss

The short condor trade will turn a loss when the price of the underlying security trades between the strike price of S3 and S2. S3 and S2 are the middle strike prices of the short condor trade. Hence a maximum loss occurs when:

S1 < S2 < Price of underlying security <  S3 < S4

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Step 7 : Maximum loss calculation

The maximum loss that a short condor faces can be calculated as:

Difference between the strike price of the lower strike long call and the lower strike short call – net credit received

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Step 8 : Limited potential profit

The profit potential of a short condor is limited to its net credit received when the trade was established. Hence, the net credit received initially is also the maximum potential profit. The maximum profit can be realised when:

  • The price of the underlying security trades above or equal to strike price of the call option with the highest strike price

or

  • The price of the underlying security trades below or equal to the strike price of the call option with the lowest strike price

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Step 9 : Maximum profit calculation for a short condor

The maximum profit can be calculated as:

Net credit received – commissions paid to the broker

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Step 10 : Calculate Risk & Reward Ratio

Once the maximum risk(loss) and reward(profit) is calculated, the options trader can go on to calculate the risk and reward ratio. This will help the trader to determine the trade’s attractiveness on a risk reward basis when compared to trades of a similar nature.

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Step 11 : Set Up Trade : Executing A Short Condor

The short condor consist of a series of short and long call option contracts with 4 different strike prices and can be quite complicated to execute for novice traders. The call options which make up the iron condor are derivatives based on the same underlying security with the same expiration date.

A short condor can also be thought of as a combination of a bear call spread and bull call spread created on the same underlying security.

A bear call spread involves :

  • Short 1 In The Money call option
  • Long 1 Out Of The Money call option

A bull call spread involves:

  • Long 1 In The Money call option
  • Short 1 Out Of The Money call

Hence, when combining the bear call spread and the bull call spread, a condor is created where:

  • Short 1 Out Of The Money call at strike price S4
  • Long 1 Out Of The Money call at strike price S3
  • Long 1 In The Money call at strike price S2
  • Short 1 In The Money call at strike price S1

The trading price of the underlying security trades between S2 and S3.

Also S4 is the greatest strike price while S1 is the smallest strike price.

Hence, 4 call option contracts at different strike prices at different expiration dates, based on the same underlying security are needed to create a short condor. The short condor trade when executed typically results in a net credit because the total premium received from shorting the call options is greater than the total premium paid for the other call options.

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Step 12 : Exit Trade & Record Trade In Diary

Exit the trade and record the trade in a diary or journal. Compare the trade’s performance to past trades. Find ways to improve the trade and to become a better trader. Analysis and reflection is an important part of a trader’s journey.

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Example of a short condor

The price of AAA Corp is currently trading at $65. An options trader anticipates a spike in volatility such that the price of AAA will significantly move up or down when the next quarterly earnings is announced.

The options trader decides to create a short condor trade by:

  • Short 1 December 75 call @ $1
  • Long 1 December 70 call @ $2
  • Long 1 December 60 call @ $7
  • Short 1 December 55 call @ $12

The net credit received is thus:

$12 + $1 – $2 – $7 = $4

$4 x 100 = $400

$400 is the net premiums or net credit received by the trader when he executes a short condor.

The upside breakeven price point is :

$75 – 44 = $71

The downside breakeven point is :

$55 + $4 = $59

If the price trades at $59 on expiration:

Beginning value Ending value Profit (+) or Loss (-)
Short 1 December 75 call $1 $0 +$1
Long 1 December 70 call $2 $0 – $2
Long 1 December 60 call $7 $0 -$7
Short 1 December 55 call $12 $4 +$8
Overall profit $0

There will be no loss or profit. Hence $59 is known as the breakeven point.

If the price trades at $71 on expiration:

Beginning value Ending value Profit (+) or Loss (-)
Short 1 December 75 call $1 $0 +$1
Long 1 December 70 call $2 $1 -$1
Long 1 December 60 call $7 $11 +$4
Short 1 December 55 call $12 $16 -$4
Overall profit $0

At $71, the upside breakeven point, there is neither profit nor loss as well.

If the price of the underlying security trades at $85 on expiration:

Beginning value Ending value Profit (+) or Loss (-)
Short 1 December 75 call $1 $10 -$9
Long 1 December 70 call $2 $15 +$13
Long 1 December 60 call $7 $25 +$18
Short 1 December 55 call $12 $30 -$18
Overall profit +$9

As you can see if there is a significant upside move beyond the strike price of the 75 (highest strike short call) , the trader’s maximum profit is still only $4. Hence, we can conclude that the maximum profit is limited. The maximum profit is realisable when the price of the underlying security is less than or equal to $55 or greater than or equal to $75.

If the price of the underlying security trades between the breakeven points, the short condor trade will experience a loss.

Read : Executing A Bull call spread

Executing A Bear call spread

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