Use Condors to Prey on This Market

Like a man trapped in a padded room, the S&P 500 has been bouncing wildly within a rather small space for the past five weeks.

The range is roughly defined by support at the 200-day moving average, which currently stands near 1158, and resistance at the 50-day moving average, which now rests around the 1180 level.

We are developing a nice tension here between a well-defined trading range and a narrowing or compression that typically, eventually leads to a breakout. If you believe, as I do, that the market will remain range-bound in the next several weeks, a condor options play may be the best way to scoop up some profits.

In two columns last week, I first focused on long butterfly spreads, emphasizing the attractive risk-reward equation of this "vacation position," then followed up on how building an inventory of these multileg spreads could provide leverage for active short-term trading. This week, I'd like to look at a strategy that employs the butterfly's limited-risk concept but shifts the focus toward a shorter time horizon, simplifying the process.

Condors, in all their varieties, are basically cousins to the butterfly, but can be a more appropriate alternative when you're looking for a stock or index to either stay within, or break out of, a trading range within a period of 30 to 60 days.

Bird of a Different Feather

The main difference between a butterfly and a condor is that while the butterfly's body consists of buying two units of the middle strike, the condor's body uses separate strikes and is therefore wider. This means it has a wider area in which its body produces a profit. For example, last week's article looked at the July 1125/1175/1225 for a net debit of $14 when the S&P was trading at 1175; this position had a maximum profit/loss of $34 to $14, or 2.57 to 1, and break-even points of 1139 and 1211.

Compare this to a condor constructed of buying the 1100 call, selling the 1150 call, selling the 1200 call and buying the 1250 call. This could have been established for a net debit of roughly $30; it's quite expensive and offers a profit/loss of just 1.5, or risking $30 to make a maximum profit of $20. But note that the maximum profit can be realized at any point between 1150 and 1200; the butterfly spread only realizes its maximum profit if the underlying security settles at the middle strike. Also, the break-even points on this condor have been expanded to 1130 and 1220. Of course, this wider profit zone and expanded break-even come at a higher cost.