Selling Condors

By James Cordier, Michael Gross, Portfolio Managers, Liberty Trading Group/OptionSellers.com

A core focus of The Complete Guide to Option Selling (McGraw-Hill 2005) is pairing the logic of selling option premium with the long term fundamentals of a particular market. For many, this means establishing a bullish or bearish position in the market at a strike price the trader feels the market will never go. Good strategy. But what many fail to realize is that there may be a strike on the other side of the market that the market will not reach either. Therefore, even if one is bullish and selling puts to collect premium, if the public is bullish and the market is moving higher, there may be calls available so far above the market that they make good sales. For a trader, it may be a case of “I’m bullish, but not that bullish.

In our last seminar, we introduced the strategy of the strangle for trading both sides of the market. In addition to doubling the premium collected, a strangle also offers good short term risk protection as losses on one side tend to be balanced by gains in the other. But this protection only lasts for so long. Eventually, if the market keeps moving adversely, the profiting option will run out of premium but the losing side will keep accruing losses. A trader has two choices then. He can either close the position and cut his loss or, if he feels his strike will not be reached, he can simply ride it out.

But for anyone who has ever “rode out” a naked option sale moving against him, the ride can get bumpy at times. Regardless of ones ultimate conviction, and aside from the fact the option is nowhere near going in the money, a continued sharp move in the underlying towards the strike can make a trader quite uncomfortable, both margin-wise and from a psychological level as he watches the option value rise – not what the option seller wants.

Enter the Condor.

There are many differences between selling condors and naked trades but one of the primary ones is comfort. Comparing a naked option sale to a condor is like comparing two travelers driving across Australia. The first takes a shortcut through the Outback in a pick up truck with no shocks. The second takes a Cadillac across a superhighway. They both eventually end up in the same place. But the Caddy sure is an easier ride – even if it takes a bit longer and costs a bit more.

Please do not misinterpret our message that writing condors is a “better” strategy than writing naked. For fundamentally based directional trades, naked option writing can work very well and can provide faster profits (or losses). But for taking advantage of high volatility, the condor offers a smoother ride. It is a matter of matching the right strategy to existing market conditions.

What is a Condor?

A condor is a type of option credit spread that combines two other types of spreads into one. A condor takes the best features of a strangle and combines them with the best features of a vertical spread (Both explained in this column in past email seminars). To put it in more simplistic terms, a condor could also be described as a covered strangle.

To establish a condor, an option seller sells an out of the money call, and then also sells an out of the money put (called a strangle). He then takes it a step further and covers (read protects) these positions by then buying a further out of the money call and buying a further out of the money put.

By structuring the trade this way, the trader effectively establishes double protection. He has the protection of a vertical spread, enhanced by the protection of a strangle. Books and educational texts that attempt to explain condors draw complex charts and “skew” lines in an attempt to illustrate maximum profit/points etc. However, for non-professional trader, these charts mean little. We will attempt to simply the strategy in this article.

The following example illustrates the use of a condor.

In January of 2008, with volatility reaching multi-year highs, a trader wishes to take a non-directional position in the silver market designed to exploit the market’s inflated option premiums. He selects the condor as his strategy.

Remember, in the condor, the trader is selling both sides of the market, puts and calls.

For his call selection, the trader elects to sell the July Silver (COMEX) $25.00 call and collects a premium of 30 cents ($1,500). To protect this position, he buys a more distant option – the $30.00 call for 15 cents ($750). The net credit (difference) is $750 which would become his profit if both options expire. This is in effect, a vertical call spread. But this is only one “wing” of the condor.

After completing the call spread, the trader sells a July Silver $12.00 put and collects a premium of 15 cents ($750). He then seeks protection for this option and therefore buys a July Silver $10.50 put for 5 cents ($250) for a net credit of $500 for this wing.

The total net credit for the condor is $1,250 ($750 +$500) which would become profit if the options expired with July Silver anywhere between $12 and $25 per ounce. Margin requirement for this particular spread is about $1,900 which makes the ROI attractive.

However, the true beauty of the condor is it’s ability to “glide” through the markets in times of turbulence.

Benefits of the Condor in Volatile Markets

The most desirable market movement for this strategy (after you are positioned) would be a slow, sideways trade. However, if the market breaks out in one direction or the other, rest assured, the condor is designed to handle it – to a certain degree. Traders who become uncomfortable with swings in the market can often exit the condor with minimal loss.

In addition, the spread allows a trader tremendous staying power in the market. For instance, if July Silver began rapidly increasing in price and began to approach the 25.00 price level, chances are the 25 call would begin increasing rapidly in value. If one were naked a call at this strike price, odds are good that his risk parameters would be triggered. However, with the covered position, the 30 call would be increasing in value almost as rapidly as the 25 call. Therefore, profits from the long 30 call are making up much of the loss on the 25 call. For this reason, in most cases, a trader can hold the calls in adverse market conditions, up until the time the underlying contract approaches or even slightly exceeds the first strike and still exit the position at that time with a manageable loss – at least much less than he would have taken in a naked option. In other words, it is a vertical spread and therefore a slower moving trade.

The long call, however, is not the short call’s only protection. Remember he sold puts in this spread too. If the market breaks out to the upside, the put side of the condor will be substantially decreasing in value and thus becoming profitable to the seller. Thus, while his call spread is increasing in value (at a slower rate than a naked option) the put spread is profiting, thus further offsetting any losses. This is why that in the example above, the trader would most likely have been able to remain in his trade even as silver prices spiked in February.

The reverse is true should the market break out to the downside. The double protection would kick in as the long put covers the short put, while the call “wing” of the trade simultaneously becomes profitable.

Another benefit of writing condors is the attractive margin treatment it gets from the exchanges. The exchanges recognize the protection offered by the spread and thus often require lower margin requirements for writing a condor than would be required for writing a naked strangle or simply writing a vertical spread on one side of the market.

Condors can be entered all at once or “legged” into by selling one side first and then the other. The strikes chosen in the previous example were our choices. However, traders can experiment with a variety of strikes to obtain their desired level of premium and risk.

Of course, there are drawbacks to any strategy and the condor has some as well. The primary drawback of using this approach is that to collect and keep the full premium credit, one must generally remain in the trade through expiration. This doesn’t sit well with more “active” traders who prefer to trade in and out of the market. Naked option selling holds an edge here because if a trader is immediately right the market and gets a large move in his favor, the naked option position can often be closed out immediately for a profit. In addition, as stated earlier, condors are generally recommended for non-directional trading and not for position trading.

The second drawback to using the condor spread is that it cannot be used in all markets and/or all situations. Some markets may not have the open interest in the desired strikes for establishing such a position, but may be more favorable to naked selling. In addition, there are also occasions where a desirable spread between strikes is simply not available. In other words, the credit between strikes is not worth the risk or is simply too small.

Another factor a trader may want to consider is that the spread must often be sold slightly closer to the money than a naked option in order to collect a similar premium. However, one must weigh this against the limited risk aspect the condor offers as opposed to selling naked.

Exit Strategy: We recommend risking a condor spread until one of the short strikes goes in the money. However, a second, more conservative strategy is to exit the position when the net credit value of the entire condor doubles from the point at which it was entered. How the risk on the position is managed depends on the personality and risk tolerance of the individual investor.

That being said, the condor is a versatile strategy that can be a powerful tool for traders seeking to profit from today’s unpredictable market gyrations.

If you have an interest in option selling or building a portfolio based on this strategy, feel free to visit us on the web at www.OptionSellers.com and request a free investor information pack (recommended for accredited investors only.)

James Cordier is the founder of Liberty Trading Group/OptionSellers.com, the first futures firm in the US to specialize exclusively in selling options. James’ market comments are featured by several international financial publications and worldwide news services including The Wall Street Journal, Yahoo Finance, CNBC and Bloomberg Television News. Michael Gross is an analyst with Liberty Trading Group. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling (McGraw-Hill 2005) is available at bookstores and online retailers now.

The information in this article has been carefully compiled from sources believed to be reliable, but it’s accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount.