Previously, we've taken a look at butterfly spreads. You’ll recall that it’s a limited risk/limited reward spread which profits from a market that doesn’t move (if you’re long the butterfly) or a market that moves quickly (if you’re short.)

Today, we’ll take a look at a closely related trade – the Condor.

It shares a lot of the same characteristics as the butterfly, but with a slightly different p/l profile.

Just like the butterfly, the long condor involves buying two options and selling two options, but the difference is that instead of selling two options in the middle on the same strike, the middle portion is stretched out to include two strikes.

In a long call condor, we buy one call, sell a call with a higher strike, sell another call with a strike that’s even higher and sell a call with a higher strike than that. Typically, to be called a condor, the strikes would all be equidistant, but that doesn’t necessarily have to be the case.

We’ll use Disney (DIS Quick QuoteDIS - Free Report) as an example.

With the stock trading around $117/share, current option prices are:

                                              Bid                       Offer

AUG 105C                            13.90                     14.10

AUG 115C                            7.10                        7.30

AUG 120C                            4.70                        4.90

AUG 130C                            1.75                        1.85

We’ll buy the August 105 calls, sell the 115 and 120 calls and buy the 130 call. Using market prices, the trade will result a $4.15 debit. (Typically, in a reduced-risk trade like this, we can get our order filled inside the bid/ask spread, but for this example, we’ll use market prices to be as fair as possible.)

Just as was the case with the butterfly, the premium paid represents the maximum possible loss. If the shares are lower than $105 or higher than $130, the spread will be worth a total of zero and we’ll lose the whole $4.15.

If the shares are trading between $115 and $120, we’ll make the maximum profit - $10.00 minus the $4.15 we paid initially for a net profit of $5.85. Our breakevens are $109.15 and $125.85

The p/l diagram looks like this:

You’ll notice that it looks similar to the p/l diagram for a butterfly, except that the maximum profit area is flatter and wider. The absolute maximum profit is also smaller in relation to the premium paid.

This stands to reason. In the butterfly, the maximum profit occurred if the stock was exactly at the middle strike at expiration. In trading vernacular, this is often referred to as “the guts.” (The outer strikes are “the wings.”)

With the condor, we have a $5 range at which the maximum profit occurs. This is a much more likely outcome - but the payoff is lower.

Both of these spreads can be useful as earnings season approaches. If you have an insight that shares of a particular stock either will (or won’t) stay in a specific price range, the condor is a great way to profit if you’re correct, while limiting the risk if your hypothesis proves incorrect.

Just as was the case with the butterfly – and virtually all options spreads - the maximum profit occurs if the stock price goes to the short strike. Because we have two short strikes, the maximum profit occurs inside a range of prices rather than at one single price.

-Dave

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