Explaining a Put Condor Option Trade...with a Twist

01/28/2010 12:01 am EST


Previously on ONN.tv, I mentioned a big trade in Goldman Sachs (NYSE: GS) puts across several strikes in the July expiration.

Today, I want to break down the details of that trade because it illustrates the versatility of options in building strategies with “customized” risk and reward. Here’s what we saw just after 10:00 am ET on Monday:

  • July 135 put: 13,600 contracts trading for $5.52
  • July 145 put: 13,600 contracts trading for $8.75
  • July 160 put: 13,600 contracts trading for $15.20
  • July 165 put: 13,600 contracts trading for $18.20

These puts all traded simultaneously as one spread, and at first glance, it looks like a condor where the investor is selling the out-of-the-money (OTM) 135/145 put spread for $3.23 and buying the in-the-money (ITM) 160/165 put spread for $3.00. This put condor thus traded for a net credit of $0.23, which is not what we usually expect of a conventional all-call or all-put condor where the strikes are equidistant and we have to pay a debit.

And also note that this is not the “iron” condor that we are so fond of here at ONN, where you sell an OTM call spread and an OTM put spread and always expect to collect a credit that you will retain if the stock stays in a range between the short strikes.

Below is a profit and loss graph of this unique GS put condor at expiration, built using the OptionsHouse Trading Tools.

Click to Enlarge

This put condor is still designed to capture profits if the stock trades in a range. In this case, maximum gains are achieved if GS shares are between $145 and $160 come July expiration. That’s when the ITM 160/165 put spread will achieve full parity value of $5.00—this plus the $0.23 credit collected initially will equal profits of $5.23 per share, or $523 per option contract. Remember, even though the trade only collects $0.23 upfront, an ITM put spread was purchased that the investor hopes will stay ITM and mature to parity, thus adding $5.00 to their haul.

In this “broken,” or “skip-strike” condor, the investor built a wider downside put spread to sell so he or she could collect more for it. Sacrificing protection by moving down to the 135 strike (vs. the 140) likely also means the investor is confident that GS shares will stay above $145, even if they are moderately bearish and believe they will stay below $160 through July.

You may also hear option traders use lingo like “unbalanced” or “lopsided” to describe unique variations of condors where quantities can also be different between strikes. Thankfully for our study here today, this one was done 1:1 with 13,600 in each strike.

The investor or institutional trader who implemented this strategy obviously had a very precise view of GS as a stock for the next six months. Let’s look specifically at the profit potential, the risks, and the breakevens they had in mind with the stock trading around $158 when they made this bet:

GS stock finishes above $165: Gain limited to $23 collected initially as the long 160/165 put spread expires worthless. 13,600 contracts x $23 = $312,800

GS stock finishes between $160 and $165: Gain = $23 plus amount by which the 165 put is in the money

GS stock finishes between $145 and $160: Max profit achieved of $523 per contract x 13,600 = $7,112,800

GS stock finishes between $135 and $145: Max profit erodes point-for-point from the max gain of $523 to the max loss of $477.

This is the value of the short 135/145 put spread ($1,000 per contract). Below the breakeven of $139.77, this trade begins to incur this loss.

GS stock finishes below $135: Max loss incurred of $477 per contract x 13,600 = $6,487,200

Buying ITM Spreads = Selling OTM Spreads

In option spread trading, the goal is to capture profits by either trading volatility or directional movement, or both. Iron condors collect their max profit potential up front in the form of the total credit received for selling two OTM spreads, one call and one put. The iron condor intends to profit from these spreads expiring worthless, or at least from time decay and/or declining volatility since the iron condor can be bought back before expiration for a profit as well.

Plain vanilla condors (all call or all put) also intend to profit by pegging a trading range in a stock, but with one of the spreads being ITM; we want this leg of the trade to expire at full parity value. In other words, we want the ITM spread to mature to full value, not expire worthless. This idea of selling an OTM spread you want to expire worthless vs. buying an ITM spread you want to expire at its full worth is really about equivalent strategies that the simple mechanics of put-call parity allow.

As the pros like to say, “Calls are puts, and puts are calls, but buys are not sells.”

By Kevin Cook of ONN.tv

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