Asymmetric Returns with a Directional Condor

The objective of any trader or investor is to achieve the greatest return for the least amount of risk. This is what you hear hedge fund and money managers referring to as “asymmetric returns”. One of the benefits of using options to participate in a directional view is the limited risk exposure of the purchased option premium compared to the theoretically unlimited profit potential.

An additional benefit of understanding the dynamics of the options market is the ability to create combinations that can further reduce our risk exposure while maintaining that asymmetrical risk/return structure.

The Debit Spread

In past articles we have reviewed the application of debit spreads as one such strategy. The debit spread involves the purchase of an at-the-money option and the subsequent sale of an option at a further out-of the-money strike price. The credit received from the out-of the-money option offsets the cost of the purchased option resulting in a lowered cost basis and break even point. The trade off is that the “spread trader” gives up the opportunity to profit beyond the written strike for the benefit of lowering the cost basis, break even point and risk of the position. This also mitigates the impact of implied volatility contraction as well as time depreciation. For more insight into this strategy you can review the M-X educational video on Advanced Option Strategies for Active Investors.

The Credit Spread

We have also dedicated significant attention to the idea of generating cash flow through credit spreads. As a refresher, the primary objective of the credit spread trader is to write (sell) an option contract with the expectation that it will expire worthless. Provided that the option contract is out-of the-money on expiration all of the time value disappears and the writer keeps the premium. The concern for some is the unidentified and theoretically unlimited risk exposure of selling “naked” options. Don’t get me wrong, naked option writing is a powerful income generating strategy but it requires sufficient margin and the investor must truly understand and manage the risks accordingly.

To limit and identify the risk of option writing, an option contract that is further out-of the-money could be purchased using a portion of the credit received. The credit spread trader still collects a premium, however the risk and margin required is limited to the spread minus the premium. For more insight on this strategy you can review the Bullish Spread Strategies and Bearish Trade Strategies videos found at www.m-x.tv.

So…what happens when you combine the two?

As I suggested in the opening paragraph, we can meet all sorts of objectives by combining the purchase and sale of various option contracts. In fact I consistently maintain that the seemingly most advanced strategies are combinations of the more simple strategies. If you understand the basics…such as debit spreads and credits spreads, you have the ingredients to construct something very interesting.

Enter the Condor

In simple terms, the Condor is constructed by combining a debit spread and credit spread with the same expiration months. The objective is to take a directional position using a debit spread, but further reduce the cost by adding a credit spread. This condor is named for its risk/reward profile and its resemblance to a big bird.

Condor Risk/Reward Profile

The maximum profit of the strategy is realized when the stock is trading between the written strikes of the combination. In this case, the debit spread is fully in-the-money and at its maximum profit, while the credit spread is out-of the-money and expires worthless resulting in the collection of the full credit.

The trade off, unlike just using a debit spread, is if the stock exceeds expectation and trades beyond the written option of the credit spread. At that point profits are diminishing as losses are being incurred on the credit spread side.

A Practical Example with Barrick

I’m sure everyone is exhausted with gold stocks, but we are seeing some renewed interest in the mining sector reflecting an appreciation in share value across the board. That said, there have been many false starts over the last year and traders are tentative to buy.

Barrick Gold (ABX.TO) is one of the most heavily traded stocks on the TSE and the options on the Montreal Exchange show good volume and liquidity. If an active investor felt there was the opportunity for continued upside into a specific price zone, but wanted reduce the cost of trading that view to enhance the asymmetric risk/reward potential, a condor could be considered.

The first trade

Buy the October, 18 strike call – $1.35 debit
Sell the October, 20 strike call – $0.60 credit

Net Cost = $0.75 (this is the maximum risk for the debit spread)
Max Profit = $1.25

• This is offers the potential for a 166% profit if the stock is trading above $20.00 on expiration
• Break even on expiration is determined by adding the cost of the spread to the purchased strike equaling $18.75