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Last week we took 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 buy a call with a higher strike than that. Typically, to be called a condor, the strikes would all be equidistant.

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

With the stock trading around \$143/share, current option prices are:

We’ll buy the August 135 calls, sell the 140 and 145 calls and buy the 150 call. Using market prices, the trade will result a \$2.30 debit.

Just as was the case with the butterfly, the premium paid represents the maximum possible loss. If the shares are lower than \$135 or higher than \$150, the spread will be worth a total of zero and we’ll lose the whole \$2.30.

If the shares are trading between \$140 and \$145, we’ll make the maximum profit, which is \$5.00, minus the \$2.30 we paid, initially for a net profit of \$2.70. Our breakevens are \$137.30 and \$142.70.

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, the middle strike is often referred to as “the guts” - and 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 - and thus the payoff is lower.

Both of these spreads can be useful as we get into the thick of earnings season. 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.

Next time: “Iron” butterflies and “Iron” condors.

-Dave

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