Make Money With The Condor Spread, Part 2
Last week I discussed the long condor spread strategy. Today I will take a look at the short condor spread.
In contrast to the long condor spread, option traders use the short condor spread when they expect high volatility. Let’s see how it works.
For a short condor, you trade four option contracts with the same expiration date and four different strike prices. You sell the options with the lowest and highest strike prices and you buy the options with the middle strike prices — the opposite of what you do in a long condor spread.
Click the link above to last week’s article if you need a memory refresher. Typically, you want to keep the distance between strike prices the same.
An Example of a Short Condor Spread
Let’s take the Snap Inc. (NSDQ: SNAP) January call for example. (If you decided to use a put option, it would work similarly.) To initiate a short condor spread, you would make the following 4 moves:
- Sell the January 16 call for $3.40 (lowest strike price)
- Buy the January 17 call for $2.85 (second lowest strike price)
- Buy the January 18 call for $2.39 (second highest strike price)
- Sell the January 19 call for $2.00 (highest strike price)
You have a credit of $5.40 ($3.40 + $2) and a debit of $5.24 ($2.85 + $2.39). Thus, you have a net credit of $16 if you traded one contract per leg (i.e., if you traded two contracts per leg, the net credit would be $32). That is also your maximum potential gain, which occurs when the stock price ends up above the highest strike price or below the lowest strike price.
If SNAP ends up below $16, all the options will expire worthless and you keep the net credit.
If SNAP ends up above $19, the options will cancel each other out. Let’s say SNAP ends up at $20 at the expiration date of the options, your gain/loss on each option would be:
- The 16 call: -$4
- The 17 call: +$3
- The 18 call: +$2
- The 19 call: -$1
The gain and loss here cancels each other out and you keep the net credit.
Your maximum loss would occur if SNAP ends up between $17 and $18. Your maximum loss would be the difference between strike prices ($1) minus the net credit of the position ($0.16), or $0.84. So your maximum loss is $84 if you traded one contract per leg.
Two Breakeven Points
There are two breakeven points: upper and lower. The upper breakeven point is the highest strike price minus the net credit. So this would occur when the stock ends up at $18.84 ($19 – $0.16). The lower one is the lowest strike price plus the net credit received. So this would occur at $16.16 ($16 + $0.16).
In other words, if SNAP ended up at lower than $16.16 or higher than $18.84 at expiration, you will end up with a profit.
In the example above, due to the pricing of the legs of the spread, the maximum potential upside is small compared to your maximum potential loss. And if you include commissions, you may not be left with much.
To get around this, you could trade more contracts for each leg. For options, brokers typically charge one big fixed fee plus a smaller variable fee based on how many contracts you trade, so if you traded more contracts you would lower the average commission cost.
It’s Possible to Gain More Profit
Also, keep in mind that the gain and loss chart above only shows what happens if you held every option to expiration. In real life option traders have the flexibility to adjust their positions.
For example, if SNAP falls to $15 and looks like it might keep falling, you could close out the two long call positions before their values fell to zero, and you can let the short call options expire. In reality you could end up making a larger profit than what we calculate above.
As you can see, when you use a short condor spread, you achieve the best result when the underlying stock makes a big move.
Consequently, the time to do a short condor spread is when you expect something to jolt the stock price, most commonly around quarterly earnings. It’s also an advanced options-trading strategy, so you may want to get comfortable with simpler option trades first or get some guidance when starting out.
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