Condors

Introduction

Just like how the strangle had a wider range than a straddle, condors can be thought of as “wider” butterflies. The rational for entering condor trades are the same as that of butterflies. The number of options that you trade are the same, except that the middle is now composed of 2 strikes instead of one.

Long Call Condor

Say you are neutral on the underlying and expect it to stabilize between a range of prices, then a Long Call Condor can be preferable over a Long Call Butterfly.

For example, with the Nifty trading at 6780, instead of doing an April 6700/6750/6800 Long Call Butterfly, you could do an April 6700/6750/6800/6850 Long Call Condor. If the Nifty ends between 6721.85 and 6828.15 at expiry, you make a profit of Rs. 1407.50 and your downside (max loss) is limited to the premium you paid (Rs. 1092.50). Note how the range of the Condor is wider [6721.85, 6828.15] vs. [6712.00, 6788.00] and the max profit is lower Rs. 1407.50 vs. Rs. 1900.00 when compared to the butterfly.

Nifty 6700-6750-6800-6850 Long Call Condor

Nifty 6700-6750-6800-6850 Long Call Condor payoff
Nifty 6700-6750-6800-6850 Long Call Condor PL

θ: helpful when the position is profitable
δ: greatest around the outer strikes, zero around the middle strikes
κ: volatility is unhelpful, unless the underlying moves outside the outer strikes
γ: peaks negatively around the middle strike and positively around the outside strikes

Short call condor

A short call condor can be used instead of a short call butterfly to speculate on increasing volatility.

For example, with the Nifty trading at 6780, instead of doing an April 6700/6750/6800 Short Call Butterfly, you could do an April 6700/6750/6800/6850 Short Call Condor. You might even end up collecting more premium than the butterfly. If the Nifty ends outside of 6721.85 and 6828.15 at expiry, you make a profit of Rs. 1092.50 and your downside (max loss) is Rs. 1407.50. Note how the range of the Condor is wider – [6721.85, 6828.15] vs. [6712.00, 6788.00] – and the max profit is higher – Rs. 1092.50 vs. Rs. 600.00 – when compared to the butterfly.

Nifty 6700-6750-6800-6850 Short Call Condor

Nifty 6700-6750-6800-6850 Short Call Condor payoff
Nifty 6700-6750-6800-6850 Short Call Condor PL

Trading condors

You should know the historical volatility of the underlying and its distribution before you get into volatility trades. As a rule of thumb, always try to position your derivative book towards being long volatility.

If the bid/ask spread is too wide, it can affect the quality of the trade. Since the losses are capped, running this trade to expiry may be tempting in such a scenario.

Related articles

Butterflies

Introduction

The butterfly can be used to bet on underlying volatility and is cheaper than straddles and strangles and without the unlimited risk.

Bearish outlook on volatility

A long call butterfly can entered when you think that the underlying stock will not rise or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower striking ITM call, writing two ATM calls and buying another higher striking OTM call.

For example, with the Nifty trading at 6780, that means entering into an April 6700/6750/6800 Long Call Butterfly. If the Nifty ends between 6712.00 and 6788.00 at expiry, you make a profit of Rs. 1900.00 and your downside (max loss) is limited to the premium you paid (Rs. 600.00)

April NIFTY 6700-6750-6800 Long Call Butterfly

April NIFTY 6700-6750-6800 Long Call Butterfly payoff
April NIFTY 6700-6750-6800 Long Call Butterfly PL

The same outlook can be expressed using puts. For example, with the Nifty trading at 6780, you can enter into an April 6700/6750/6800 Long Put Butterfly. If the Nifty ends between 6707.75 and 6792.25 at expiry, you make a profit of Rs. 2112.50 and your downside (max loss) is limited to the premium you paid (Rs. 387.50) In this case, the Long Put Butterfly makes more sense: it costs less, the expected P&L is higher and the break-evens are wider.

April NIFTY 6700-6750-6800 Long Put Butterfly

April NIFTY 6700-6750-6800 Long Put Butterfly payoff
April NIFTY 6700-6750-6800 Long Put Butterfly PL

γ: runs from positive to negative. γ is negative when the stock is at the middle strike. This indicates that the butterfly will manufacture negative δs if the stock price rises, and positive δs if the stock price falls. This is precisely what you don’t want to happen. That’s why the long butterfly wants the price of the stock to stay right where it is when it’s at the middle strike.

θ: positive when the price of the stock is at the middle strike, indicating that time passing helps the long butterfly reach its maximum value. At the outer strikes theta is negative, indicating that the butterfly is losing value as time passes.

κ is negative when the stock price is at the middle strike. That means that any increased implied volatility in the stock will decrease the value of the butterfly. κ is positive for the long butterfly at the outer strikes. Therefore, an increase in the implied volatility of the stock increases the value of the butterfly because of the greater likelihood that the stock will move toward the middle strike by expiration.

Bullish outlook on volatility

A Short Call Butterfly allows you to collect premiums if you can wait out uncertainty. For example, with the Nifty trading at 6780, you can enter into an April 6700/6750/6800 Short Call Butterfly. If the Nifty ends below 6712.00 or above 6788.00 then you lose Rs. 1900.00 (difference in strikes – premium received). Otherwise, you get to keep the option premium you collected (Max: Rs. 600.00)

NIFTY April 6700-6750-6800 Short Call Butterfly

NIFTY April 6700-6750-6800 Short Call Butterfly payoff
NIFTY April 6700-6750-6800 Short Call Butterfly PL

The same view can be expressed using a Short Put Butterfly. For example, with the Nifty trading at 6780, you can enter into an April 6700/6750/6800 Short Put Butterfly. If the Nifty ends below 6707.75 or above 6707.75 then you lose Rs. 2112.50 (difference in strikes – premium received). Otherwise, you get to keep the option premium you collected (Max: Rs. 387.50)

NIFTY April 6700-6750-6800 Short Put Butterfly

NIFTY April 6700-6750-6800 Short Put Butterfly payoff
NIFTY April 6700-6750-6800 Short Put Butterfly pl

θ: helpful when the position is profitable
δ: greatest around the outer strikes, zero around the middle strike
κ: volatility is helpful, unless the underlying moves outside the outer strikes
γ: peaks positively around the middle strike and negatively around the outside strikes

Trading butterflies

You should know the historical volatility of the underlying and its distribution before you get into volatility trades. As a rule of thumb, always try to position your derivative book towards being long volatility.

If the bid/ask spread is too wide, it can affect the quality of the trade. Since the losses are capped, running this trade to expiry may be tempting in such a scenario.

Source: ThinkOrSwim

Long Strangle

Introduction

Straddles can be expensive. A slightly less expensive, but more bullish strategy is the strangle. Instead of ATMs in the case of the straddles, you buy a slightly OTM (out-of-the-money) put and a slightly OTM call.

May NIFTY 6750/6800 Long Strangle

With the NIFTY trading at ~6780, you buy the 6750 Put and the 6800 Call.

May NIFTY 6750-6800 Long Strangle

Strangles have a wider break-evens than straddles. So they are bigger bullish call on volatility than straddles. In this case, the break-evens are 6188.50 are 7361.50

May NIFTY 6750-6800 Long Strangle payoff
May NIFTY 6750-6800 Long Strangle PL

Exiting the trade

Just like in straddles, time is not your friend here. You can either exit the trade right before the event occurs – when implied volatility is at its highest or soon after the event (irrespective of the magnitude of the movement.)

The lack of liquidity means that you are forced to put this trade on closer to expiry and that is exactly the time when θ-decay is at its highest. And the wider break-evens mean that movement in the underlying has to be larger for the trade to work.

Understanding Nifty Volatility

Definition

Volatility (σ) is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices. There are different ways of calculating volatility. At StockViz, we use Yang Zhang Volatility.

σ is one of the biggest contributor of option premiums. Understanding its true nature will help you trade it better.

Volatility spikes

Observe the volatility spikes since 2005. Even though the average is around 0.3, its not uncommon to have huge swings.

nifty-volatility

Fat tails abound

nifty-volatility-10-histogram

nifty-volatility-20-histogram

nifty-volatility-30-histogram

nifty-volatility-50-histogram

Trading strategy

Always try to be on the long-side of volatility. It might be tempting, while trading options, to try and clip the carry on θ-decay. But you should always be aware of the fat-tails of volatility that can crush many months of carry P&L overnight.

Short Straddle

Introduction

While discussing the subject of the Long Straddle, we touched upon three things:

  1. Most of the obvious uncertainties are priced in. So you better have a unique point of view.
  2. Time is not your friend.
  3. The lack of liquidity means that you are forced to put this trade on closer to expiry and that is exactly the time when θ-decay is at its highest.

What if you invert the trade? This is exactly what the short straddle is made of. You can enter this trade soon after an widely anticipated event occurs and implied-volatility is at its highest.

Construction

This strategy consists of selling a call option and a put option with the same strike price and expiration.

NIFTY 6750 short straddle

The θ-decay now works for you. Sell ATM nearest-expiration options, collect the carry and laugh all the way to the bank, right?

NIFTY 6750 short straddle payoff
NIFTY 6750 short straddle pl

Not so fast! If the NIFTY breaks-out above 6836.50 or below 6663.50, then you are exposed to ∞ loss. It is up to you to figure out if the Rs. 4325.00 you are getting is enough compensation for insuring against the likelihood of that breakout.

Exiting the trade

Time is your friend and volatility is your enemy. When you sell insurance of this kind, you are exposed to external events that may not have anticipated and that occur outside of market hours. If you see volatility creep up, its best to exit this trade, even if at a loss.