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| June 2007 |
| Market News | Features | Key Statistics | Trading Calendar | Contact |
The New Options will not be published in July and August. Enjoy the sun!
| Market News | ||
| New listings | ||||
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Addition of options classes * (as of June 25, 2007) Inmet Mining Corp. – IMN Oilexco Inc. – OIL Sino-Forest Corporation – TRE * Pending CDCC’s and market makers’ approvals |
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| Consultation on proposed changes to procedures applicable to the execution of cross transactions and the execution of prearranged transactions |
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The Montréal Exchange is in the process of reviewing its market model. We would like to inform you of changes that are being considered to the procedures applicable to the execution of cross and prearranged transactions in the options market. Your input is important to our decision making process and the result of this consultation will contribute directly to the way our options market model evolves in the near future. Read more... |
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| Starting in September, we are planning to change how the New Options newsletter is distributed.
With the growing popularity of the Option Matters blog, we intend to publish all features of the newsletter directly in the blog. Advantages reside in the speed of access and the frequency of option-related news trsansmission. Instead of a monthly publication, you will benefit from information as soon as it is available. We invite you share your comments, ideas and suggestions. |
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| Features | ||
| Trading strategies: condors and credit spreads Richard N. Croft Croft Financial Group |
Part II: Setting up condors – too much trouble or worth the trouble?
Part I: Understanding the trade, the risk and the potential
There has been talk recently—on blogs or option websites—around an exotic option strategy known as the condor. Much of it being negative commentary, with stories citing examples of managed option accounts losing 50% to 60% of their value because of the pain inflicted by the condor strategy.
I find it interesting that such losses occur when, 1) by all accounts, the condor is considered a low risk neutral spread and 2), is designed to exploit the noise that drives short-term performance in the equity markets.
Perhaps we have answered our own question. In many ways, the condor plays in the same space as equity hedge funds. And like most hedge funds, the risk is not the strategy, it is the leverage used to take advantage of the strategy.
Using a more liberal definition, the condor is a limited risk volatility play with low or negative correlation to traditional asset classes. Within a broader portfolio, a condor can reduce portfolio risk and enhance return. As long as you are able to control the leverage employed within the strategy.
With that in mind, we will examine the condor in two articles. This article will define the strategy, and outline the risks and potential. Part II, will bring to bear some statistical analysis to help employ the strategy successfully.
A combination of credit spreads
A condor is really a combination of two out-of-the-money credit spreads; one bullish and one bearish.
A credit spread involves the simultaneous purchase and sale of a call or put option with different strike prices. A credit spread occurs when the option that is sold has a value greater than the option that is purchased.
The risk in a properly constructed spread is limited and therefore, benefits from preferential margin treatment. Limited risk can only be established if the long option expires at the same time or after the short option.
Credit spreads can be established with either calls or puts and can be bullish or bearish. For example, suppose XYZ is trading at $50 per share with the following prices for the XYZ two-month options (see Table 1).
Table 1: XYZ at $50 per share
| Calls | Strike | Puts |
| 6.400 | 45.00 | 1.100 |
| 4.750 | 47.50 | 1.950 |
| 3.350 | 50.00 | 3.050 |
| 2.350 | 52.50 | 4.550 |
| 1.550 | 55.00 | 6.250 |
A bullish credit spread must involve puts. In this case, you could sell XYZ 47.50 puts at $1.95 and simultaneously buy the XYZ 45 puts at $1.10. This put spread creates a net credit of $0.85, the difference between the premium received from the sale of the XYZ 47.50 put and the premium paid to buy the XYZ 45 put.
This spread is bullish because the maximum return occurs if XYZ stays the same, declines slightly, or rises. At any price above $47.50 per share (strike price of the short put), both puts expire worthless and the investor pockets the net premium received.
A bearish credit spread must involve call options. For example, buying XYZ 55 calls at $1.55, and selling XYZ 52.50 calls at $2.35. The credit for this position is $0.80, the difference between the premium received from the sale of the XYZ 52.50 call versus the premium paid for the XYZ 55 call.
This spread is bearish because the maximum return occurs if XYZ stays the same, declines or even rises slightly. As long as XYZ is below the $52.50 per share strike price of the short call option at expiration, both calls expire worthless and the investor pockets the net premium received.
Creating the condor
In the XYZ example, we have established out-of-the-money credit spreads. A bullish put spread and a bearish call spread. If we simply combine the XYZ out-of-the-money credit spreads, we have created the iron condor. Traders refer to this as an “iron condor” because upside and downside risk is limited.
The finished product is described in Table 2.
Table 2: The Iron Condor
| Position | Strike Price | Premium |
| Short | XYZ 52.50 Call | 2.35 |
| Long | XYZ 55 Call | 1.55 |
| Short | XYZ 47.50 Put | 1.95 |
| Long | XYZ 45 Put | 1.10 |
| Net credit received | 1.65 | |
Note the net credit of $1.65 per share is the total premium received from the two credit spreads. The XYZ iron condor spread will be profitable if XYZ closes at expiration between the strike prices of the two short options. At any price between $47.50 and $52.50 per share, all four options will expire worthless and the investor pockets the net premium received.
The maximum risk occurs if XYZ moves beyond both wings of the condor, which in the case, is the strike price of the long options. If at expiration, XYZ closed above $55 per shared or below $45 per share, one spread would have a maximum loss, while the other would expire worthless delivering its maximum profit.
For example, let’s assume at expiration that XYZ closed at $60. The put options would both expire worthless and you would pocket that premium. However, you would have to repurchase the XYZ 52.50 calls at $7.50 per share, for a net loss on that option of $5.15 per share. Fortunately, you would also sell your XYZ 55 calls for $5.00 per share, offsetting some of the loss on the XYZ 52.50 calls. Table 3 looks at the net loss on the position if XYZ closed at $60 per share.
Table 3: Results if XYZ closes at $60 at expiration
| Position | Strike Price | Premium | Results at Expiration | Gain (Loss) |
| Short | XYZ 52.50 Call | 2.35 | Buy call at $7.50 | (5.15) |
| Long | XYZ 55 Call | 1.55 | Sell call at $5.00 | 3.45 |
| Short | XYZ 47.50 Put | 1.10 | Expire | 1.95 |
| Long | XYZ 45 Put | 1.95 | Expire | (1.10) |
| Net per share loss | (0.85) | |||
Note that at any price above $55 per share, losses will occur on the short XYZ 52.50 calls, but will be offset dollar for dollar by gains on the XYZ 55 calls. As such, the maximum loss at expiration regardless what happens to XYZ will be $0.85 per share.
That’s the advantage of the condor spread, and why it has gained so much attention in recent months. Your loss is limited by the outside “wings” (i.e. the long option strike prices) of the strategy, and your maximum gain occurs if the stock remains in a relatively tight trading range.
Part II: Setting up condors – too much trouble or worth the trouble?
In the previous column we looked at a more popular exotic spread… the iron condor. Timing is not critical when dealing with the condor strategy, because it is essentially a neutral volatility trade. It will work as long as the underlying security remains in a trading range until the condor expires.
Not an unreasonable expectation, if you believe that equities typically trade within a range that is one standard deviation around a mean. When break outs occur, it is usually the result of an unexpected event; an earnings report that was better than expected, an unexpected change in interest rates, etc.
Condors profit when the underlying remains within the boundaries of its trading range. The condor has the highest probability of success when there is a lack of news to drive markets up or down. Some analysts think that may be exactly the environment we will see through the summer.
As discussed in part I of this series, the iron condor strategy is a short combination using out-of-the-money bear call spreads and out-of-the-money bull put spreads. That’s four separate option contracts and four separate trades (note: some brokerage firms will trade spreads on a single ticket) as part of a single trade. As you would expect, it is important to always evaluate this strategy net of transaction costs.
Establishing iron condors
The next step is to look at how one should implement the strategy so that it has the best chance of success. Obviously you want to trade options that statistically have a high probably of expiring worthless. To get there, use volatility to select striking prices that are 1.0, 1.5 or 2.0 standard deviations out-of-the-money.
If you use volatility to establish an implied trading range, you can then work with strike prices that are outside that range. You would buy options – known as the wings of the iron condor—using strikes above and below the short options.
Let’s look at a real life example using options on Nortel Networks (symbol NT, recent price $27.95). The NT options are trading with an implied volatility of 34%.
To establish an implied trading range for the period in question, we need to first recognize that the 34% implied volatility assumption is an annualized number. Basically, the options market is suggesting that over the next year, a one standard deviation trading range for Nortel would be $37.45 on the upside to $18.45 on the downside.
To get that value, I simply multiply the current stock price ($27.95) by 34% which equals $9.50. If I add $9.50 to the current price ($27.95) I get my upside, if I subtract $9.50 I get my downside number.
Obviously, I am using the most rudimentary version of volatility to come up with these numbers. If you are mathematically inclined, I would suggest you utilize a spreadsheet to encapsulate the data more appropriately—perhaps using logs. A more accurate assessment of the implied trading range will emerge, but for the purposes of this column, the rudimentary examination serves the educational purpose.
So with the prerequisite apology to the mathematically challenged among us, we need to take this volatility calculation one step further in order to establish our statistical distance for the time period in question. Remember the volatility number is annualized, so the trading range implied by the volatility number is an annual trading range. Not very helpful when dealing with say, a four month option contract.
To compare apples to apples, we need to look at the statistical trading range over the next sixteen weeks, which is when the September options will expire. Which means converting the annual volatility number into a sixteen week volatility number.
To get that number we multiply the annual volatility (34%) by the square root of time. In this case, time is 16 weeks to expiration divided by 52 weeks in a year. When we multiply the annual implied volatility by the square root of time (16/52), we end up with an implied volatility of 18.9% over the next four months.
That implies a trading range bracketed by $5.25 to the upside and downside. The so-called implied trading range between now and the September expiration is $33.20 on the upside and $22.70 on the downside.
From a statistical perspective, we could establish the iron condor by writing the Nortel September 32 calls at 80 cents and the Nortel September 25 puts at 90 cents. This nets us a premium of $1.70 from the sale of the two options.
To create the wings of the iron condor, we would purchase September 35 calls at 30 cents and the September 23 puts at 40 cents. The net premium received, which is simply the premium earned from the sale of the call and put less the premium paid for the wings of the condor is $1.00.
The profit range for this position is $24 (25 put strike price less $1.00 net credit) on the downside and $33 (32 call strike plus $1.00 credit) on the upside. If at the September expiration, Nortel closes at any price between the high and low as defined, the position should net a profit. Obviously the trading range will be narrowed by the cost of implementing the trade.
On the surface, this would seem to be an excellent strategy. And theoretically, it has a reasonable probability of success. Although when dealing with individual stocks, company specific events can occur which renders moot the statistical significance of the volatility assumption. Fortunately, in a worst case scenario the upside and downside risk is limited by the wings of the iron condor.
Because of the company specific risks associated with individual companies, many condor spreaders prefer to use index options. Since by definition an index removes company specific risk from the equation, you are left to deal only with market risk. That too can be a problem, but the chances of a statistical anomaly occurring in an index is less than it is with an individual stock.
Disclaimer
The opinions expressed in these articles bind the author only and do not represent in any way Bourse de Montréal Inc.’s opinion. The information provided in these articles, including financial and economic data, quotes and any analysis or interpretation thereof, is provided solely on an information basis and shall not be interpreted in any jurisdiction as an advice or a recommendation with respect to the purchase or sale of any derivative instrument, underlying security or any other financial instrument or as a legal, accounting, tax, financial or investment advice. Bourse de Montréal Inc. recommends that you consult your own advisors in accordance with your needs. Although care has been taken in the preparation of these articles, Bourse de Montréal Inc. takes no responsibility for errors or omissions and it reserves itself the right to amend, review or delete, at any time and without prior notice, the content of these articles. Bourse de Montréal Inc., its directors, officers, employees and agents will not be liable for damages, losses or costs incurred as a result of the use of any information appearing in these articles.
| Key Statistics | ||
| Contracts | Volume May 2007 |
Volume Jan. – May 2007 |
Volume Jan. – May 2006 |
% Change |
| Equity options | 1,205,751 | 5,218,820 | 5,087,653 | 1.1% |
| ETF options | 82,214 | 298,577 | 371,071 | -15.3% |
| Options on the US dollar |
3,911 | 12,907 | 18,674 | -30.9% |
| Interest rate derivatives | 3,120,901 | 12,668,743 | 10,304,181 | 22.9% |
| Index derivatives | 179,653 | 1,216,907 | 947,508 | 28.4% |
| TOTAL MARKET | 4,592,430 | 19,415,954 | 16,729,087 | 16.1% |
| Contracts | Open Interest May 2007 |
Open Interest May 2006 |
% Change |
| Equity options | 1,632,970 | 1,392,533 | 17.3% |
| ETF options |
124,427 | 110,823 | 12.3% |
| Options on the US dollar |
3,218 | 4,338 | -25.8% |
| Interest rate derivatives | 1,017,958 | 921,872 | 10.4% |
| Index derivatives | 192,275 | 163,224 | 17.8% |
| TOTAL MARKET | 2,970,848 | 5,592,790 | 14.6% |
| MX Implied Volatility Index (MVX) | ||
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| The MVX Index shows the degree of uncertainty perceived by investors in the stock market. The higher the level of the index, the higher the uncertainty. | ||
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| Canadian Equity Options Market | ||
| Traded volume distribution per sector - May 2007 |
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* Sectors breakdowns are based on the S&P/TSX indices. |
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