Execute A Condor : Profit From Low Volatility

Introduction To Condor

Execute A Condor

The condor options strategy is used when the price of the underlying security is expected to have little to no volatility. This strategy aims to profit from low volatility conditions and it has a limited loss and profit profile. Overall, the condor is a strategy with a reasonable risk curve with a wide potential profit range.  The trader who executes this strategy knows that the maximum profit can be attained within the breakeven points. This will be further elaborated in the section below.

Condor results in a net debit

When a condor is executed, a debit results. This is because the premiums collected from the sale of options is less than that collected from the buying of calls.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook : Range bound markets
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5 : Understand Your Profit Zones
Step 6 : Limited potential losses
Step 7 : Calculate Maximum Loss
Step 8 : Understand That Profit Is Capped
Step 9 : Learn To Calculate Profit Of A Condor
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up A Condor
Step 12 : General guidelines for exiting the condor trade
Step 13 : Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

Economic fundamental technical analysis

The trader should perform economic, fundamental and technical analysis to determine the direction of the markets. There should also be no economic events that may cause the price of the underlying security to move in a volatile fashion. Over the life of the condor, the trader predicts little to no volatility in the price of the underlying security. You can read more above economic analysis, fundamental analysis and technical analysis on this website. One suggestion is that option traders can  look out for chart patterns such as :

The breakeven price points should have a range that is nearly equal or smaller than the trading range of an underlying security. There should also be an firmly established resistance and support level that is horizontal as above.

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Step 2 :Outlook : Range bound markets

After Step 3 has been performed, the options trader should be convinced of low volatility conditions in the underlying security. If that happens, the trader stands to make a limited profit. Hence, range bound markets that will trade between the upside and downside breakeven points are required for the strategy to earn a maximum profit.

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Step 3 :Study the option chain

 

The options trader should now look at the  strike prices or the option contracts that he is interested in, mindful to select a situation in which the smallest net debit is paid.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

The  condor is marked by 2 breakeven points. At these 2 breakeven points, there is neither profit nor loss. These breakeven points are important to a trader as it tells a trader graphically the price at which the underlying security must trade at for the condor strategy to be profitable.

The upside breakeven point is calculated as:

Strike price of the call with the greatest Strike price – net debit

The downside breakeven point is calculated as :

Strike price of the call with the lowest strike price + net debit

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Step 5: Understand Your Profit Zones

 

Execute A Condor

Once breakeven analysis has been performed, the trader should use the breakeven points are markers to determine profit zones. If the price of the underlying security trades between the breakeven points, the trader will earn a maximum profit.

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Step 6 : Limited potential losses

A condor is established by using calls with 4 different strike prices, S1, S2, S3 and S4.

S1 < S2 < S3 < S4

The maximum loss occurs when the price of the underlying security is less than or equal to S1 and more than or equal to S4. Hence, a maximum loss occurs when the price of the underlying security is less than or equal to the lowest strike price or greater than or equal to the highest strike price.

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Step 7 : Calculate Maximum Loss

The maximum loss can be calculated as :

Net debit + commissions paid to broker

The net debit is also the net premiums paid to initiate the condor.

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Step 8 :  Understand That Profit Is Capped

In order for the condor to be profitable, the price of the underlying security must trade within a certain band of prices. There are 4 options with 4 different strike prices as the condor is established. To explain this further, there are 4 strike prices of calls on which the condor is executed, that is, S1, S2, S3 and S4.

S1 < S2 < S3 < S4

To establish a condor a call is bought at strike price S1, a call is written at strike price S2, A call is written at strike price S3 and a call is bought at strike price S4.

Looking at the inequality above,it means the call with a strike price of S1 has a lower strike than a call with a strike price of S4.  S2 is a lower strike call than S3. Hence, S2 and S3 are the middle strike prices of the condor. For the trade to have a maximum profit, the price of the underlying security must trade within a narrow band of S2 and S3.

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Step 9 : Learn To Calculate Profit Of A Condor

The maximum profit can be calculated as :

S2 – S1 – net debit of the trade – commissions paid to broker

Do note that the maximum profit occurs when the price of the underlying security trades between S2 and S3.

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Step 10 : Calculate Risk & Reward Ratio

After you have calculated the maximum loss and maximum potential profit, you can calculate the risk and reward ratio. A higher risk and reward ratio relative to the other condor trades you have executed in the past is what you should look for. This  is also the reason it is essential to minimise the net debit.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up A Condor

  • Buy a 1 lower strike in the money call options contract
  • Sell 1 in the money call options contract

The long call contract has a lower strike price than the written call contract

AND

  • Sell 1 out of the money call options contract
  • Buy 1 higher strike out of the money call options contract

The written call here has a lower strike price than that of the long call.

Hence, there is a bought leg, a sold leg, a sold leg and a bought leg all in incrementally higher strike prices. A condor strategy is essentially a combination of a bull call spread and a bear call spread.

All option contracts have identical expiration months and are derived from the same underlying security. The general advice by professional option traders is to use options which are at least 45 days out. By doing so, as the price of the underlying security trades between a narrow band of prices, time premium is collected from the shorted options and the condor may earn the maximum profit.

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Step 12 : General guidelines for exiting the condor trade

  1. If the price of the underlying security is trading between the downside and upside breakeven points, a profit is realisable. If the condor has already experienced reasonable profit of 50% or more and there are 30 days left till expiration, consider closing the trade entirely especially if market conditions have changed and there is a chance of the underlying trading outside of the breakeven points for the remaining life of the options.
  2. Let the options expire worthless when the price of the underlying security trades below the downside breakeven point. In a scenario like this, the net debit is the maximum loss.
  3. Close out the entire condor trade if the price of the underlying security is trading above the upside breakeven point as there is a prospect of assignment. If assignment occurs, exercise the long options to cover the assigned underlying.

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Step 13 : Record Trade In Diary

After you have exited the condor, note the trade in a trading diary. Learn from you past mistakes and improve on your processes.

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Example

A company EEE Corp is trading at a price of $35. A trader initiates a condor by buying a December 25 call, write a December 30 call, write a December 40 call and buy a December 45 call. The December 25 call, December 30 call, December 40 call and  December 45 cost $1080, $690, $190 and $100 respectively.

The net debit is thus:

$1080 + $100 – $690 – $190 = $300

When the EEE trades at $25, all the options will expire worthless. In that case, the maximum possible loss is $300, the net debit or premiums paid.

When EEE trades at $45, the December 45 call with expire worthless.

The December 25 call , December 30 call and December 40 call will expire with intrinsic values of $2000, $1500 and $500 respectively.

The gain on the December 25 call is:

$2000 – $1080 = $920

The loss on the December 30 call is:

$1500 – $690 = $810

The loss on the December 40 call is :

$500 – $190 = $310

The total loss is:

$810 + $310 + $100( loss on December 45 call ) – $920 = 300

As you can see the total loss is limited to $300 and it occurs when the trading price is less than or equal to the lowest strike price or greater than or equal to the highest strike price.

If the trading price of EEE is $35, the December 25 call and the December 30 call will expire in the money. Do take a look at the table below. An easy way to calculate net profit or loss is to compare beginning values of the option versus its ending value on expiration date of the options.

Option Beginning value Ending value Profit or loss
December 25 call $1080 $1000 Loss = $80
December 30 call $690 $500 Gain = $190
December 40 call $190 $0 Gain = $190
December 45 call $100 $0 Loss = $100

The total net profit if EEE trades at $35 is :

$190 + $190 – $80 – $100 = $200

As you can see, when the price of the underlying security trades between $30 and $40, the maximum profit is $200.

Another way to calculate the maximum profit is :

($30 – $25) x 100 – $300 = $200

$300 is the net debit. Please refer to the formula above.

Condor strategy requires high commissions

Since the condor requires four separate legs and is actually a combination of a bull call spread and a bear call spread, commissions will have to be paid on all 4 legs. An option trader considering the use of a condor should negotiate the commissions payable to the broker if he expects to trade a large quantity as this will affect the size of his potential profits.

Short condor

A short condor is a strategy that also uses call options but projects the volatility of the underlying security to be high. A long condor strategy however projects low volatility on the underlying security, hoping that the price of the security trades within a band of prices. The short condor is a modification of the long condor.

Iron condor

A long condor is executed with a net debit while an iron condor is executed with a net credit. A iron condor is constructed with both puts and calls while a long condor is constructed with just calls.

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