10/27/2017 Short Condor Spread with Puts - Fidelity

Short condor spread with puts

THE OPTIONS INSTITUTE AT CBOE

Bearish

Goal
To pro it from a stock price move up or down beyond the highest or lowest strike prices of the position.

Explanation
A short condor spread with puts is a four-part strategy
Example of short condor spread with
that is created by selling one put at a higher strike price,
puts
buying one put with a lower strike price, buying another
put with an even lower strike price and selling one more Sell 1 XYZ 110 Put at 8.25 8.25
put with an even lower strike price. All puts have the same Buy 1 XYZ 105 Put at 4.65 (4.65)
expiration date, and the strike prices are equidistant. In Buy 1 XYZ 100 Put at 2.10 (2.10)
Sell 1 XYZ 95 Put at 0.70 0.70
the example above, one 110 Put is sold, one 105 Put is
Net Credit = 2.20
purchased, one 100 Put is purchased, and one 95 Put is
sold. This strategy is established for a net credit, and both
the potential pro it and maximum risk are limited. The
maximum pro it is equal to the net premium received less commissions, and it is realized if the stock price
is above the higher strike price or below the lower strike price at expiration. The maximum risk equals the
distance between the center and lower strike prices less the net premium received, and a loss of this
amount incurred if the stock price is equal to the center strike price (long puts) on the expiration date.

This is an advanced strategy because the pro it potential is small in dollar terms and because costs are
high. Given that there are four strike prices, there are multiple commissions and bid-ask spreads when
opening the position and again when closing it. As a result, it is essential to open and close the position at
good prices. It is also important to trade a condor with acceptable risk/reward ratios.

Maximum profit
The maximum pro it potential is the net credit received less commissions, and there are two possible
outcomes in which a pro it of this amount is realized. If the stock price is above the highest strike price at
expiration, then all puts expire worthless and the net credit is kept as income. Also, if the stock price is
below the lowest strike price at expiration, then all puts are in the money and the condor spread position
has a net value of zero. As a result, the net credit less commissions is kept as income.

Maximum risk
The maximum risk is equal to the difference between the strike prices less the net credit received minus
commissions, and a loss of this amount is realized if the stock price is at or between the middle strike
prices at expiration.

In the example above, the difference between the strike prices is 5.00, and the net credit received is 2.20,
not including commissions. The maximum risk, therefore, is 2.80 less commissions.

Breakeven stock price at expiration

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There are two breakeven points. The lower breakeven point is the stock price equal to the lowest strike
price plus the net credit received. The upper breakeven point is the stock price equal to the highest strike
price minus the net credit.

Profit/Loss diagram and table: short condor spread with puts

Sell 1 XYZ 110 Put at 8.25 8.25
Buy 1 XYZ 105 Puts at 4.65 (4.65)
Buy 1 XYZ 100 Put at 2.10 (2.10)
Sell 1 XYZ 95 Put at 0.70 0.70
Net Credit = 2.20

Stock Price Short 1 110 Long 1 105 Long 1 100 Put Short 1 95 Put Net
at Put Put Pro it/(Loss)at Pro it/(Loss)At Pro it/(Loss)
Expiration Pro it/(Loss) Pro it/(Loss) Expiration Expiration at Expiration
at Expiration at Expiration

115 +8.25 (4.65) (2.10) +0.70 +2.20

110 +8.25 (4.65) (2.10) +0.70 +2.20

105 +3.25 (4.65) (2.10) +0.70 (2.80)

100 (1.75) +0.35 (2.10) +0.70 (2.80)

95 (6.75) +5.35 +2.90 +0.70 +2.20

90 (11.75) +5.35 +2.90 (4.30) +2.20

Appropriate market forecast

A short condor spread with puts realizes its maximum pro it if the stock price is above the higher strike or
below the lower strike on the expiration date. The forecast, therefore, must be for high volatility, i.e., a
stock price move outside the range of the strike prices of the condor.

Strategy discussion
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A short condor spread with puts is the strategy of choice when the forecast is for a stock price move
outside the range of the highest and lowest strike prices. Unlike a long straddle or long strangle, however,
the pro it potential of a short condor spread is limited. Also, the commissions for a condor spread are
higher than for a straddle or strangle. The tradeoff is that a short condor spread has breakeven points much
closer to the current stock price than a comparable long straddle or long strangle.

Condor spreads are sensitive to changes in volatility (see Impact of Change in Volatility). The net price of a
condor spread falls when volatility rises and rises when volatility falls. Consequently some traders
establish a short condor spread when they believe that volatility is low and forecast that it will rise. Since
the volatility in option prices typically rises as an earnings announcement date approaches and then falls
immediately after the announcement, some traders will sell a condor spread seven to ten days before an
earnings report and then close the position on the day before the report. Success of this approach to selling
condor spreads requires that either the volatility in option prices rises or that the stock price rises or falls
outside the strike price range. If the stock price remains constant and if implied volatility does not rise,
then a loss will be incurred.

Patience and trading discipline are required when trading short condor spreads. Patience is required
because this strategy pro its from stock price movement and/or rising implied volatility, and stock price
action can be unsettling as it rises and falls between the lower and upper strike prices as expiration
approaches. Trading discipline is required, because, as expiration approaches, small changes in the
underlying stock price can have a high percentage impact on the price of a condor spread. Traders must,
therefore, be disciplined in taking partial pro its if possible and also in taking small losses before the
losses become big.

Impact of stock price change

Delta estimates how much a position will change in price as the stock price changes. Long puts have
negative deltas, and short puts have positive deltas.

If the stock price is between the lowest and highest strike prices, then, regardless of time to expiration, the
net delta of a short condor spread remains close to zero until a few days before expiration. If the stock price
is above the highest strike price in a short condor spread with puts, then the net delta is slightly positive. If
the stock price is below the lowest strike price, then the net delta is slightly negative. Overall, a short
condor spread with puts pro its from a stock price rise or fall outside the range of strike prices in the
spread and is hurt by time decay.

Impact of change in volatility

Volatility is a measure of how much a stock price luctuates in percentage terms, and volatility is a factor in
option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to
expiration remain constant. Long options, therefore, rise in price and make money when volatility rises,
and short options rise in price and lose money when volatility rises. When volatility falls, the opposite
happens; long options lose money and short options make money. Vega is a measure of how much
changing volatility affects the net price of a position.

Short condor spreads with puts have a negative vega. This means that the price of a short condor spread
falls when volatility rises (and the spread makes money). When volatility falls, the price of a short condor
spread rises (and the spread loses money). Short condor spreads, therefore, should be established when
volatility is low and forecast to rise.

Impact of time

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The time value portion of an options total price decreases as expiration approaches. This is known as time
erosion. Theta is a measure of how much time erosion affects the net price of a position. Long option
positions have negative theta, which means they lose money from time erosion, if other factors remain
constant; and short options have positive theta, which means they make money from time erosion.

A short condor spread with puts has a net negative theta it loses from time decay as long as the stock
price is in a range between the lowest and highest strike prices. If the stock price moves out of this range,
however, the theta becomes positive as expiration approaches.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and holders of short stock option
positions have no control over when they will be required to ful ill the obligation. Therefore, the risk of
early assignment is a real risk that must be considered when entering into positions involving short
options.

While the long puts (middle two strike prices) in a short condor spread have no risk of early assignment,
the short puts do have such risk. Early assignment of stock options is generally related to dividends. Short
puts that are assigned early are generally assigned on the ex-dividend date. In-the-money puts whose time
value is less than the dividend have a high likelihood of being assigned.

If one short put is assigned (most likely the highest-strike short put), then 100 shares of stock are
purchased and the long puts (middle two strikes) and the other short put remain open. If a long stock
position is not wanted, it can be closed in one of two ways. First, 100 shares can be sold in the marketplace.
Second, the long 100-share position can be closed by exercising the higher-strike long put. Remember,
however, that exercising a long put will forfeit the time value of that put. Therefore, it is generally
preferable to sell shares to close the short stock position and then sell the long put. This two-part action
recovers the time value of the long put. One caveat is commissions. Selling shares to close the long stock
position and then selling the long put is only advantageous if the commissions are less than the time value
of the long put.

If both of the short puts are assigned, then 200 shares of stock are purchased and the long puts (middle
strike prices) remain open. Again, if a long stock position is not wanted, it can be closed in one of two ways.
Either 200 shares can be sold in the marketplace, or both long puts can be exercised. However, as discussed
above, since exercising a long put forfeits the time value, it is generally preferable to sell shares to close the
long stock position and then sell the long puts. The caveat, as mentioned above, is commissions. Selling
shares to close the long position and then selling the long puts is only advantageous if the commissions are
less than the time value of the long puts.

Note, however, that whichever method is used, selling stock and selling the long put or exercising the long
put, the date of the stock sale will be one day later than the date of the purchase. This difference will result
in additional fees, including interest charges and commissions. Assignment of a short option might also
trigger a margin call if there is not suf icient account equity to support the stock position created.

Potential position created at expiration

The position at expiration of a short condor spread with puts depends on the relationship of the stock price
to the strike prices of the spread. If the stock price is above the highest strike price, then all puts expire
worthless, and no position is created.

If the stock price is below the highest strike and at or above the second-highest strike, then the highest
strike short put is assigned, and the other three puts expire worthless. The result is that 100 shares of stock
are purchased and a stock position of long 100 shares is created.

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If the stock price is below the second-highest strike and at or above the second-lowest strike, then the
highest strike short put is exercised and the second-highest strike long put is exercised. The result is that
100 shares are purchased and 100 shares are sold. The net result is no position, although one stock buy
commission and one stock sell commission have been incurred.

If the stock price is below the second-lowest strike and at or above the lowest strike, then the highest-
strike short put is assigned, and both middle-strike long puts are exercised. The result is that 100 shares
are purchased and 200 shares are sold. The net result is a stock position of short 100 shares.

If the stock price is below the lowest strike, then both long puts (middle two strikes) are exercised and the
two short puts (highest and lowest strikes) are assigned. The result is that 200 shares are purchased and
200 shares are sold. The net result is no position, although two stock buy and sell commissions have been
incurred.

Other considerations
A short condor spread with puts can also be described as the combination of a bull put spread and a bear
put spread. The bull put spread is the short highest-strike put combined with the long second-highest
strike put, and the bear put spread is the long second-lowest strike put combined with the short lowest-
strike put.

The term condor in the strategy name is thought to have originated from the pro it-loss diagram. A
condor is a bird with an exceptionally long wing span for its body size. The horizontal line representing the
range of maximum pro it in the middle of the diagram for a long condor spread looks vaguely like the body
a condor and the horizontal lines stretching out above the highest strike and below the lowest strike look
vaguely like the wings of a condor. A short condor spread looks vaguely like an upside-down condor.

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Related Strategies
Long condor spread with puts
A long condor spread with puts is a four-part strategy that is created by buying one put at a higher strike
price, selling one put with a lower strike price, selling another put with an even lower strike price and
buying one more put with an even lower strike price.

Short condor spread with calls

A short condor spread with calls is a four-part strategy that is created by selling one call at a lower strike
price, buying one call with a higher strike price, buying another call with an even higher strike price and
selling one more call with an even higher strike price.

Article copyright 2013 by Chicago Board Options Exchange, Inc (CBOE). Reprinted with permission from CBOE. The statements and
opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any
statements or data.

Options trading entails signi icant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk.
Before trading options, please read Characteristics and Risks of Standardized Options . Supporting documentation for any claims, if
applicable, will be furnished upon request.

Charts, screenshots, company stock symbols and examples contained in this module are for illustrative purposes only.

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