The Directional Condor

  • SumoMe

For too many people the model is basically, “The stock market goes up I make money, the stock market goes down I lose money.”  As I have already demonstrated here, here, here and here, there are ways to make money that are not reliant on a bull market in the stock market. In addition, via the use of options you can “craft” a position to achieve just about any objective you have in mind. So today let’s take a look at another trading possibility that most people will never consider.

Ticker SPY

Ticker SPY is an ETF tracks the price of the S&P 500 Index.

Figure 1 displays the bar chart for ticker SPY.1Figure 1 – Ticker SPY price with implied volatility; Price oversold, implied option volatility high (Courtesy www.OptionsAnalysis.com)

As you can see:

*We have seen a sharp sell off into an oversold condition

*We have a “line in the sand” support level of 181.02

*Implied option volatility is well above average (implying that there is above average time premium built into the price of SPY options)

So let’s say a trader wants to find a trade that:

#1. Enjoys unlimited profit potential if SPY rallies

#2. Can make decent money if SPY remains relatively unchanged

#3. Can make decent money as long as SPY remains above the previous low

#4. Can take advantage of a potential decline in implied option volatility

OK, that’s kind of asking a lot, but let’s see what we can come up with.

The Directional Condor Spread

Take a look at the trade presented in Figures 2 and 3.  With ticker SPY trading at 191.21 this trade involves:

*Buying 6 Mar 206 calls @ 0.25

*Selling 4 Mar 204 calls @ 0.42

*Selling 4 Mar 182 puts @ 2.92

*Buying 4 Mar 177 puts @ 1.96

2Figure 2 – SPY Directional Condor Spread Details (Courtesy www.OptionsAnalysis.com)

3Figure 3 – SPY Directional Condor Spread Risk Curves (Courtesy www.OptionsAnalysis.com)

A few things to note:

*The trade has unlimited profit potential and will earn the initial credit of $402 if SPY is between 182 and 204 at March expiration.

*The maximum risk (and the amount need to put up to enter the trade) is $1,598. However, a loss of this size would only be realized if the trade is held until March option expiration and SPY is at or below 177.00 at that time.

*If we trigger a stop-loss if SPY drops below $181, the resulting loss on the trade will be roughly -$425 to -$450.

So let’s go back to or original “Wish List”

#1. Enjoys unlimited profit potential if SPY rallies?

SPY would have to rally fairly significantly to rack up large gains.  Still, unlimited potential exists; unlike with a standard consider spread.

#2. Can make decent money if SPY remains relatively unchanged?

The trade will earn a profit of $402 if SPY is between 182 and 204 at March expiration

#3. Can make decent money as long as SPY remains above the previous low?

SPY is trading at $191.21.  The recent low was 181.02 and the breakeven price on this trade is 180.99.

#4. Can take advantage of a potential decline in implied option volatility?

See Figures 4 and 5.

If Volatility Falls

In the stock market, stock index option implied volatility typically (though not always), rises when the stock market falls and declines when the stock market falls or remains neutral.  So if SPY rises or meanders then chances are implied option volatility will fall. Because this trade involves “selling premium” it can benefit from declining volatility.

Figure 4 displays the risk curves through 3/3/2016 for this trade and highlights the expected profit if price and volatility are unchanged at that time (expected open profit = +$213).4Figure 4 – If price and volatility unchanged as of 3/3/16 (Courtesy www.OptionsAnalysis.com)

Figure 5 displays the risk curves through 3/3/2016 for this trade and highlights the expected profit if price is unchanged BUT volatility declines by 25% from current levels by that time (expected open profit = +$320).5aFigure 5 – If price is unchanged BUT volatility declines by 25% as of 3/3/16 (Courtesy www.OptionsAnalysis.com)

Summary

Is this a good trade?  That depends on how you define “good”. If you had the objectives listed earlier than this trade creates the opportunity to take advantage of the present price and volatility action for SPY.

Is this destined to be a profitable trade?  That’s another question altogether.

Jay Kaeppel

 

One thought on “The Directional Condor

  1. Thanks Jay. Really like the idea behind this trade. Risk is defined and there is the possibility of “unlimited” profit.

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