Basics of Spreading: Butterflies and Condors

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1 1 of 31 Basics of Spreading: Butterflies and Condors What is a Spread? Review the links below for detailed information. Terms and Characterizations: Part 1 Download What is a Spread? Download: Butterflies and Condors Terms & Characterizations: Part 2 Spread Order Execution Calculating Profit & Loss Early Assignment Risk More on Terminology The Strategies The spreads discussed in this series, may be categorized with respect to their risk/reward profiles. Profit limited & Loss limited Moderately Bullish Moderately Bearish Neutral Bull Call Spread X Bear Call Spread X Bear Put Spread X Bull Put Spread X Long Call Time Spread X Long Put Time Spread X Long Call Butterfly X Long Put Butterfly X Iron Butterfly X Long Call Condor X Long Put Condor X Iron Condor X Profit not limited & Loss limited Very Bullish Very Bearish Neutral Long Straddle X Long Strangle X Call Backspread X Put Backspread X Profit limited & Loss not limited Neutral to slightly Bullish Neutral to slightly Bearish Neutral Ratio Call Spread X Ratio Put Spread X

2 2 of 31 Short Straddle X Short Strangle X NOTE: For each spread example discussed in this class it is assumed that all transactions are opening ones. In other words, an investor would initially have no position, but after making the transactions described would have the spread position under discussion. In order to simplify the computations, commissions and other costs have not been included in the examples used in this course and may be significant. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. Long Call Butterfly General Nature & Characteristics The long call butterfly spread is made up entirely of call options on the same underlying stock (or index). It s constructed by purchasing one call with a given strike price, selling (writing) two calls with a higher strike price, and purchasing one call with an even higher strike price. All calls have the same expiration month, and the increment between strike prices is the same. The ratio of long to short to long calls is always 1:2:1. The result is a position comprised of one long call (lowest strike), two short calls (middle strike) and one long call (highest strike). An investor with this position can be said to be long a call butterfly spread or to have bought a call butterfly spread. Long call butterfly = buy 1 lowest-strike call + sell 2 middle-strike calls + buy 1 highest-strike call Debit vs. Credit A long call butterfly spread will always be established at a net debit. In other words, the amount of cash paid out for the two long calls (different strikes) is more than the cash received for the two written calls (middle strike). Long call butterfly = debit spread Example To establish a long call butterfly spread with XYZ options, an investor might buy 1 XYZ June 55 call for $6.00, sell (write) 2 XYZ June 60 calls for $2.75 and buy 1 XYZ June 65 call for $1.00. The result is the investor being long 1 XYZ June 55/60/65 call butterfly spread, at a $1.50 ($6.00 $ $1.00) net debit. XYZ June 55/60/65 Long Call Butterfly Action Quoted Price* Total Price* Buy 1 XYZ June 55 call - $ $ Sell 2 XYZ June 60 calls + $2.75 x 2 + $ Buy 1 XYZ June 65 call - $ $ Net Debit - $ $ *Excluding commissions XYZ June 55/60/65 Long Call Butterfly Long 1 XYZ June 55 call Short 2 XYZ June 60 calls Long 1 XYZ June 65 call

3 of 31 Expectation The long call butterfly spread is a neutral position. An investor employing this strategy is neutral on the underlying stock (or index), and expects it to stabilize around the middle strike price of the short calls until expiration. As well, the investor wants a decrease in option implied volatility that could enhance profitability before expiration, perhaps with even more of a move in the underlying stock price (or index level) than expected. Long call butterfly: neutral Motivation for Spreading Just as a straddle seller is neutral on the underlying stock, so is the holder of a long call butterfly. Both investors expect the underlying stock (or index) to stabilize around a specific strike price, and to profit from time decay as well as a possible decrease in volatility. By creating a long call butterfly spread, however, an investor can avoid the up- and downside risk involved with a short straddle. Long call butterfly: reduced (limited) risk Risk vs. Reward Maximum Profit The maximum profit for a long call butterfly spread is limited. This profit will be seen if the underlying stock (or index) closes at the middle strike price of the short calls at expiration. In this case, the maximum profit is equal to the strike price differential (difference in strike prices) less the debit paid for the butterfly. Maximum profit = limited (Underlying at middle strike at expiration) Maximum Loss The maximum loss for a long call butterfly spread is limited entirely to the net debit initially paid for it. This loss will be seen if the underlying stock (or index) closes at or below the lowest strike price, or at or above the highest strike price at expiration, no matter how high or low the underlying stock price (or index level) moves. Maximum loss = limited to debit paid (Underlying at/below lowest strike or at/above highest strike at expiration) Break-Even Point There are two break-even points (BEPs) for a long call butterfly at expiration, one to the upside and one to the downside. The upside break-even point is a closing underlying stock price (or index level) equal to the highest strike price minus the debit initially paid for the spread. The downside break-even point, on the other hand, is equal to the lowest strike price plus the debit paid. Upside break-even point = highest strike price debit paid Downside break-even point = lowest strike price + debit paid

4 of 31 Partial Profit At expiration, if the underlying stock (or index) closes at a point between the middle strike price, and either the up- or downside break-even point, a partial profit would be seen. Profit & Loss Before Expiration Before expiration, an investor can take a profit or cut a loss by selling the spread if it has market value. This involves selling the long calls and buying the short calls, which will be done at a net credit, and these closing trades may be executed simultaneously in one spread transaction. Profit or loss would simply be the net difference between the debit initially paid for the spread and the credit received at its sale. Effect of Volatility An increase in volatility has a negative effect on the long call butterfly; a decrease in volatility on the other hand has a positive effect. Effect of Time Decay

5 of 31 Time decay has a positive effect on the long call butterfly, and this effect increases at a faster rate as expiration nears. Long Call Butterfly - Continued Example XYZ June 55/60/65 Long Call Butterfly Long 1 XYZ June 55 call Short 2 XYZ June 60 calls Long 1 XYZ June 65 call Net debit = $1.50 ($150 total) Maximum Profit The maximum profit for this long call butterfly spread is limited and would be seen if the underlying stock (or index) closes at the middle strike price of the short calls, or $60, at expiration. In this case, the maximum profit would be equal to the $5.00 difference in strike prices less the $1.50 debit paid for the butterfly = $3.50 or $350 total. Maximum profit = $5.00 strike difference $1.50 debit paid = $3.50, or $350 total Maximum Loss At expiration, if the underlying stock (or index) closes at or below the lowest strike price of $55, or at or above the highest strike price of $65, the maximum loss for this long call butterfly would be limited to the net $1.50 debit paid for the spread, or $150 total. Maximum loss = $1.50 debit paid, or $150 total Break-Even Point At expiration, the upside break-even point for this long call butterfly would be a closing underlying stock price (or index level) equal to $65 (highest strike price) $1.50 (debit paid) = $ The downside break-even point would be with the underlying stock (or index) closing at $55 (lowest strike price) + $1.50 (debit paid) = $ Upside break-even point = $65 strike $1.50 debit paid = $63.50 Downside break-even point = $55 strike + $1.50 debit paid = $56.50

6 of 31 XYZ Price Long 55 Call Long XYZ June 55/60/65 Call Butterfly Paid $1.50 Net Debit = $150 Total Results at Expiration Short 2 60 Calls Long 65 Call of Spread Butterfly Profit/Loss* 70 + $1500 $ $500 0 $ $1000 $ $ $850 $ $ $700 $ $300 + $ $ $500 + $ $ $300 + $ $ $ $ $150 *Excluding commissions Assignment Risk Assignment on any Equity option or American-style index option can, by contract terms, occur at any time before expiration, although this generally occurs when the option is in-the-money. Equity Options For an equity call option, early assignment usually occurs under specific circumstances; such as when underlying shareholders are about to be paid a dividend. Assignment at that time might be expected when the dividend amount is greater than the time value in the call s premium, and notice of assignment may be received as late as the ex-dividend date. If a long call butterfly spread holder is assigned early on in-the-money short calls, then he may exercise as many long calls and buy shares to fulfill the assignment obligation. If assigned on more short calls than in-the-money calls he is long, then he must either purchase underlying shares for delivery to fulfill his assignment obligation, or take a short position in those shares. American-Style Index Options If early assignment is received on in-the-money short calls of a long call butterfly spread, the cash settlement procedure for index options will create a debit in the investor s brokerage account equal to the cash settlement amount. This cash amount is determined at the end of the day the long call is exercised by its owner. After receiving assignment notification, usually the next business day, when the investor exercises his long calls the cash settlement amount credited to his account will be determined at the end of that day. There is a full day s market risk if the long option is not sold during the trading day assignment is received. If assigned on more short calls than in-the-money calls he is long, the cash settlement procedure will create a debit in the investor s brokerage account equal to the cash settlement amount. Long Put Butterfly General Nature & Characteristics The long put butterfly spread is made up entirely of put options on the same underlying stock (or index). It s constructed by purchasing one put with a given strike price, selling (writing) two puts with a higher strike price, and purchasing one put with an even higher strike price. All puts have the same expiration month

7 7 of 31, and the increment between strike prices is the same. The ratio of long to short to long puts is always 1:2:1. The result is a position comprised of one long put (lowest strike), two short puts (middle strike) and one long put (highest strike). An investor with this position can be said to be long a put butterfly spread, or to have bought a put butterfly spread. Long put butterfly = buy 1 lowest-strike put + sell 2 middle-strike puts + buy 1 highest-strike put Debit vs. Credit A long put butterfly spread will always be established at a net debit. In other words, the amount of cash paid out for the two long puts (different strikes) is more than the cash received for the two written puts (middle strike). Long put butterfly = debit spread Example To establish a long put butterfly spread with XYZ options, an investor might buy 1 XYZ June 55 put for $0.75, sell (write) 2 XYZ June 60 puts for $2.75 and buy 1 XYZ June 65 put for $5.75. The result is the investor being long 1 XYZ June 65/60/55 put butterfly spread, at a $1.00 ($0.75 $ $5.75) net debit. XYZ June 55/60/65 Long Put Butterfly Action Quoted Price* Total Price* Buy 1 XYZ June 55 put - $ $75.00 Sell 2 XYZ June 60 putss + $2.75 x 2 + $ Buy 1 XYZ June 65 put - $ $ Net Debit - $ $ *Excluding commissions XYZ June 55/60/65 Long Put Butterfly Long 1 XYZ June 55 put Short 2 XYZ June 60 puts Long 1 XYZ June 65 put Expectation The long put butterfly spread is a neutral position. An investor employing this strategy is neutral on the underlying stock (or index), and expects it to stabilize around the middle strike price of the short puts until expiration. As well, the investor wants a decrease in option implied volatility that could enhance profitability before expiration, perhaps with even more of a move in underlying stock price (or index level) than expected. Long put butterfly: neutral Motivation for Spreading Just as a straddle seller is neutral on the underlying stock, so is the holder of a long put butterfly. Both investors expect the underlying stock (or index) to stabilize around a specific strike price, and to profit from time decay as well as a possible decrease in volatility. By creating a long put butterfly spread, however, an investor can avoid the up- and downside risk involved with a short straddle. Long put butterfly: reduced (limited) risk

8 8 of 31 Risk vs. Reward Maximum Profit The maximum profit for a long put butterfly spread is limited. This profit will be seen if the underlying stock (or index) closes at the middle strike price of the short puts at expiration. In this case, the maximum profit is equal to the strike price differential (difference in strike prices) less the debit paid for the butterfly. Maximum profit = limited (Underlying at middle strike at expiration) Maximum Loss The maximum loss for a long put butterfly spread is limited entirely to the net debit initially paid for it. This loss will be seen if the underlying stock (or index) closes at or below the lowest strike price, or at or above the highest strike price at expiration, no matter how high or low the underlying stock price (or index level) moves. Maximum loss = limited to debit paid (Underlying at/below lowest strike or at/above highest strike at expiration) Break-Even Point There are two break-even points (BEPs) for a long put butterfly at expiration, one to the upside and one to the downside. The upside break-even point is a closing underlying stock price (or index level) equal to the highest strike price minus the debit initially paid for the spread. The downside break-even point, on the other hand, is equal to the lowest strike price plus the debit paid. Upside break-even point = highest strike price debit paid Downside break-even point = lowest strike price + debit paid Partial Profit At expiration, if the underlying stock (or index) closes at a point between the middle strike price, and either the up- or downside break-even point, a partial profit would be seen.

9 of 31 Profit & Loss Before Expiration Before expiration, an investor can take a profit or cut a loss by closing the spread. This involves selling the long puts and buying the short puts, which will be done at a net credit, and these closing trades may be executed simultaneously in one spread transaction. Profit or loss would simply be the net difference between the debit initially paid for the spread and the credit received at its sale. Effect of Volatility An increase in volatility has a negative effect on the long put butterfly; a decrease in volatility on the other hand has a positive effect. Effect of Time Decay Time decay has a positive effect on the long put butterfly, and this effect increases at a faster rate as expiration nears. Long Put Butterfly - Continued Example XYZ June 55/60/65 Long Put Butterfly Long 1 XYZ June 55 put Short 2 XYZ June 60 puts Long 1 XYZ June 65 put Net debit = $1.00 ($100 total) Maximum Profit The maximum profit for this long put butterfly spread is limited and would be seen if the underlying stock (or index) closes at the middle strike price of the short puts, or $60, at expiration. In this case, the maximum profit would be equal to the $5.00 difference in strike prices less the $1.00 debit paid for the butterfly = $4.00 or $400 total. Maximum profit = $5.00 strike difference $1.00 debit paid = $4.00, or $400 total Maximum Loss At expiration, if the underlying stock (or index) closes at or below the lowest strike price of $55, or at or above the highest strike price of $65, the maximum loss for this long put butterfly would be limited to

10 0 of 31 the net $1.00 debit paid for the spread, or $100 total. Maximum loss = $1.00 debit paid, or $100 total Break-Even Point At expiration, the upside break-even point for this long put butterfly would be a closing underlying stock price (or index level) equal to $65 (highest strike price) $1.00 (debit paid) = $ The downside break-even point would be with the underlying stock (or index) closing at $55 (lowest strike price) + $1.00 (debit paid) = $ Upside break-even point = $65 strike $1.00 debit paid = $64.00 Downside break-even point = $55 strike + $1.00 debit paid = $56.00 XYZ Price Long 55 Put Long XYZ June 55/60/65 Put Butterfly Paid $1.00 Net Debit = $100 Total Results at Expiration Short 2 60 Puts Long 65 Put of Spread Butterfly Profit/Loss* $ $ $100 + $ $300 + $300 + $ $500 + $500 + $ $400 + $700 + $300 + $ $800 + $900 + $ $ $ $ $500 $ $ $100 *Excluding commissions Assignment Risk

11 11 of 31 Assignment on any Equity option or American-style index option can, by contract terms, occur at any time before expiration, although this generally occurs when the option is in-the-money. Equity Options For an equity put option, early assignment generally occurs when the short put is deep in-the-money, expiration is relatively near, and its premium has little or no time value. If a long put butterfly spread holder is assigned early on in-the-money short puts, then he may exercise as many long puts and sell shares purchased via the assignment obligation. If assigned on more short puts than in-the-money puts he is long, then he must purchase underlying shares. American-Style Index Options If early assignment is received on in-the-money short puts of a long put butterfly spread, the cash settlement procedure for index options will create a debit in the investor s brokerage account equal to the cash settlement amount. This cash amount is determined at the end of the day the long put is exercised by its owner. After receiving assignment notification, usually the next business day, when the investor exercises his long puts the cash settlement amount credited to his account will be determined at the end of that day. There is a full day s market risk if the long option is not sold during the trading day assignment is received. If assigned on more short puts than in-the-money puts he is long, the cash settlement procedure will create a debit in the investors brokerage account equal to the cash settlement amount. Iron Butterfly General Nature & Characteristics A long synthetic, or iron, butterfly spread is made up of both call options and put options on the same underlying stock (or index). It s constructed by purchasing one put with a given strike price, selling one call and one put with a higher strike price, and purchasing one call with an even higher strike price. All options have the same expiration month, and the increment between strike prices is the same. The ratio of long put to short call & put to long call is always 1:2:1. The result is a position comprised of one long put (lowest strike), a short call and a short put (middle strike) and one long call (highest strike). An investor with this position can be said to be long (or hold) an iron butterfly spread, or long (hold) a synthetic butterfly spread. Long iron butterfly = buy 1 lowest-strike put + sell 1 call & 1 put with middle-strike + buy 1 higheststrike call Note: There are two ways to view the composition of this iron butterfly spread. First, it is a short straddle (short call & put with middle strike), with the downside protected by a long put (lowest strike) and the upside protected by a long call (highest strike). Or second, it is constructed with two vertical spreads: a bull put spread (long lowest-strike put and short middle-strike put) and a bear call spread (long highest-strike call and short middle-strike call). Even though this spread is established at a net credit, it may be considered long because the profit & loss profile resembles a long call or long put butterfly. Debit vs. Credit A long iron butterfly spread constructed in the above manner will always be established at a net credit. In other words, the amount of cash paid out for the two long options (call & put) is less than the cash received for the two written options (call & put). Long iron butterfly = credit spread Example To establish a long iron butterfly spread with XYZ options, an investor might buy 1 XYZ June 55 put for $0.75, sell (write) 1 XYZ June 60 put for $2.50 and 1 XYZ June 60 call for $2.80, and buy 1 XYZ June 65 call for $1.00. The result is the investor being long 1 XYZ June 55/60/65 iron butterfly spread, at a

12 12 of 31 $3.55 ( $ $ $2.50 $1.00) net credit. Long XYZ June 55/60/65 Iron Butterfly Action Quoted Price* Total Price* Buy 1 XYZ June 55 put $0.75 $75.00 Sell 1 XYZ June 60 put + $ $ Sell 1 XYZ June 60 call + $ $ Buy 1 XYZ June 65 call $1.00 $ Net Credit + $ $ *Excluding commissions Long XYZ June 55/60/65 Iron Butterfly Long 1 XYZ June 55 put Short 1 XYZ June 60 put Short 1 XYZ June 60 call Long 1 XYZ June 65 call Expectation The long iron butterfly spread is a neutral position. An investor employing this strategy is neutral on the underlying stock (or index), and expects it to stabilize around the middle strike price of the short call and put until expiration. As well, the investor wants a decrease in option implied volatility that could enhance profitability before expiration, perhaps with even more of a move in the underlying stock price (or index level) than expected. Long iron butterfly: neutral Motivation for Spreading Just as a straddle seller is neutral on the underlying stock, so is the holder of a long iron butterfly. Both investors expect the underlying stock (or index) to stabilize around a specific strike price, and to profit from time decay as well as a possible decrease in volatility. By creating a long iron butterfly spread, however, an investor can avoid the up- and downside risk involved with a short straddle. Long iron butterfly: reduced (limited) risk Risk vs. Reward Maximum Profit The maximum profit for a long iron butterfly spread is limited. This profit will be seen if the underlying stock (or index) closes at the middle strike price of the short call and put at expiration. In this case, the maximum profit is equal to the credit received when establishing the spread. Maximum profit = limited to credit received (Underlying at middle strike at expiration) Maximum Loss The maximum loss for a long iron butterfly spread is limited entirely to the strike price differential (difference in strikes) less the credit initially received when the spread is established. This loss will be seen if the underlying stock (or index) closes at or below the lowest strike price (long put), or at or above the highest strike price at expiration (long call), no matter how high or low the underlying stock

13 13 of 31 price (or index level) moves. Maximum loss = limited to strike price differential credit received (Underlying at/below lowest strike or at/above highest strike at expiration) Break-Even Point There are two break-even points (BEPs) for a long iron butterfly at expiration, one to the upside and one to the downside. The upside break-even point is a closing underlying stock price (or index level) equal to the middle strike price plus the credit initially received for the spread. The downside break-even point, on the other hand, is equal to the middle strike price less the credit received. Upside break-even point = middle strike price + credit received Downside break-even point = middle strike price credit received Partial Profit At expiration, if the underlying stock (or index) closes at a point between the middle strike price, and either the up- or downside break-even point, a partial profit would be seen.

14 4 of 31 Profit & Loss Before Expiration Before expiration, an investor can take a profit or cut a loss by closing the spread if it has market value. This involves selling the long call and put and buying the short call and put, which will be done at a net debit, and these closing trades may be executed simultaneously in one spread transaction. Profit or loss would simply be the net difference between the credit initially received for the spread and the debit paid at its closing. Effect of Volatility An increase in volatility has a negative effect on the long iron butterfly; a decrease in volatility on the other hand has a positive effect. Effect of Time Decay Time decay has a positive effect on the long iron butterfly, and this effect increases at a faster rate as expiration nears. Iron Butterfly - Continued Example Long XYZ June 55/60/65 Iron Butterfly Long 1 XYZ June 55 put Short 1 XYZ June 60 put Short 1 XYZ June 60 call Long 1 XYZ June 65 call Net credit = $3.55 ($355 total) Maximum Profit The maximum profit for this long iron butterfly spread is limited, and would be seen if the underlying stock (or index) closes at the middle strike price of the short call and short put, or $60, at expiration. In this case, the maximum profit would be equal to the $3.55 credit initially received for the spread, or $355 total. Maximum profit = $3.55 credit received, or $355 total Maximum Loss At expiration, if the underlying stock (or index) closes at or below the lowest strike price of $55 (long put), or at or above the highest strike price of $65 (long call), the maximum loss for this long iron butterfly would be limited to the $5.00 strike price differential $3.55 credit initially received for the spread = $1.45, or $145 total. Maximum loss = $5.00 strike differential $3.55 credit received = $1.45, or $145 total Break-Even Point At expiration, the upside break-even point for this long iron butterfly would be a closing underlying stock price (or index level) equal to $60 (middle strike price) + $3.55 (credit received) = $ The downside break-even point would be with the underlying stock (or index) closing at $60 (middle strike price) $3.55 (credit received) = $ Upside break-even point = $60 strike + $3.55 debit paid = $63.55 Downside break-even point = $60 strike $3.55 debit paid = $56.45

15 5 of 31 XYZ Price Long 55 Put Long XYZ June 55/60/65 Iron Butterfly Received $3.55 Net Credit = $355 Total Results at Expiration Short 60 Put Short 60 Call Long 65 Call of Spread Butterfly Profit/Loss* $ $500 $500 $ $500 0 $500 $ $355 0 $ $200 0 $200 + $ $ $ $200 + $ $ $ $ $500 $ $500 $ $500 $145 *Excluding commissions Assignment Risk Assignment on any Equity option or American-style index option can, by contract terms, occur at any time before expiration, although this generally occurs when the option is in-the-money. Equity Options For an equity call option, early assignment usually occurs under specific circumstances; such as when underlying shareholders are about to be paid a dividend. Assignment at that time might be expected when the dividend amount is greater than the time value in the call s premium, and notice of assignment may be received as late as the ex-dividend date. If a long iron butterfly holder is assigned early on the short call, then he must deliver underlying shares by either exercising his long call if it is in-the-money, purchasing them in the marketplace (at a realized

16 16 of 31 loss), or by taking a short stock position. He would still retain the rest of the iron butterfly position. For an equity put option, early assignment generally occurs when the short put is deep in-the-money, expiration is relatively near, and its premium has little or no time value. If a long iron butterfly holder is assigned early on the short put, he must buy underlying shares. Then, he may exercise his long put, if it is in-the-money, and sell those shares, or take a long stock position. He would still retain the rest of the iron butterfly position. American-Style Index Options If early assignment is received on an in-the-money short call (or put) of a long iron butterfly spread, the cash settlement procedure for index options will create a debit in the investor s brokerage account equal to the cash settlement amount. This cash amount is determined at the end of the day the long call (or put) is exercised by its owner. After receiving assignment notification, usually the next business day, if his long call (or put) is also in-the-money the investor may exercise that contract. The cash settlement amount credited to his account will be determined at the end of that day, and there is a full day s market risk if the long option is not sold during the trading day assignment is received. If the long call (or put) is not in-the-money, after the cash settlement amount is debited from his account via assignment the investor would still retain the rest of the iron butterfly position. Long Call Condor General Nature & Characteristics The long call condor spread is made up entirely of call options on the same underlying stock (or index). It s constructed by purchasing one call with the lowest strike price, selling (writing) a call with a higher strike price, selling (writing) another call with an even higher strike price, and purchasing a call with the highest strike price. All calls have the same expiration month, and the increment between strike prices is the same. The ratio of long to short to short to long calls is always 1:1:1:1. The result is a position comprised of one long call (lowest strike), two short calls (2 middle strike prices) and one long call (highest strike). An investor with this position can be said to be long a call condor spread. Long call condor = buy 1 lowest-strike call + sell 1 higher-strike call + sell 1 even higher-strike call + buy 1 highest-strike call Note: One way to view a long call condor spread is as a long call butterfly with the two short calls one strike price apart. For this reason you might see this spread referred to as a flat-top butterfly or an elongated butterfly. Debit vs. Credit A long call condor spread will always be established at a net debit. In other words, the amount of cash paid out for the two long calls (highest and lowest strikes) is more than the cash received for the two written calls (middle strikes). Long call condor = debit spread Example To establish a long call condor spread with XYZ options, an investor might buy 1 XYZ June 55 call for $7.90, sell 1 XYZ June 60 call for $4.35, sell 1 XYZ June 65 call for $1.85, and buy 1 XYZ June 70 call for $0.50. The result is the investor being long 1 XYZ June 55/60/65/70 call condor spread, at a $2.20 ( $ $ $1.85 $0.50) net debit.

17 17 of 31 Long XYZ June 55/60/65/70 Call Condor Action Quoted Price* Total Price* Buy 1 XYZ June 55 call - $ $ Sell 1 XYZ June 60 call + $ $ Sell 1 XYZ June 65 call + $ $ Buy 1 XYZ June 70 call - $ $50.00 Net Debit - $ $ *Excluding commissions Long XYZ June 55/60/65/70 Call Condor Long 1 XYZ June 55 call Short 1 XYZ June 60 call Short 1 XYZ June 65 call Long 1 XYZ June 70 call Expectation The long call condor spread is a neutral position. An investor employing this strategy is neutral on the underlying stock (or index), and expects it to stabilize between the two middle strike prices of the short calls until expiration. As well, the investor wants a decrease in option implied volatility that could enhance profitability before expiration, perhaps with even more of a move in the underlying stock price (or index level) than expected. Long call condor: neutral Motivation for Spreading Just as a long call butterfly holder is neutral on the underlying stock, so is the holder of a long call condor. The buyer of a call condor, however, can see maximum profit over a range of closing underlying stock prices (or index levels) at expiration, instead of at a single strike price like the long call butterfly holder. Long call condor: increased chance of profitability Risk vs. Reward Maximum Profit The maximum profit for a long call condor spread is limited. This profit will be seen if the underlying stock (or index) closes at or between the two middle strike prices of the short calls at expiration. The maximum profit amount is equal to the strike price differential (difference in strike prices) less the debit paid for the condor. Maximum profit = limited (Underlying at/between 2 middle strikes at expiration) Maximum Loss The maximum loss for a long call condor spread is limited entirely to the net debit initially paid for it. This loss will be seen if the underlying stock (or index) closes at or below the lowest strike price, or at or above the highest strike price at expiration, no matter how high or low the underlying stock price (or index level) moves. Maximum loss = limited to debit paid

18 8 of 31 (Underlying at/below lowest strike or at/above highest strike at expiration) Break-Even Point There are two break-even points (BEPs) for a long call condor at expiration, one to the upside and one to the downside. The upside break-even point is a closing underlying stock price (or index level) equal to the highest strike price minus the debit initially paid for the spread. The downside break-even point, on the other hand, is equal to the lowest strike price plus the debit paid. Upside break-even point = highest strike price debit paid Downside break-even point = lowest strike price + debit paid Partial Profit At expiration, if the underlying stock (or index) closes at a point between the middle strike prices, and either the up- or downside break-even point, a partial profit would be seen. Profit & Loss Before Expiration Before expiration, an investor can take a profit or cut a loss by selling the spread if it has market value. This involves selling the long calls and buying the short calls, which will be done at a net credit, and these closing trades may be executed simultaneously in one spread transaction. Profit or loss would simply be the net difference between the debit initially paid for the spread and the credit received at its

19 9 of 31 sale. Effect of Volatility An increase in volatility has a negative effect on the long call condor; a decrease in volatility on the other hand has a positive effect. Effect of Time Decay Time decay has a positive effect on the long call condor, and this effect increases at a faster rate as expiration nears. Long Call Condor - Continued Example Long XYZ June 55/60/65/70 Call Condor Long 1 XYZ June 55 call Short 1 XYZ June 60 call Short 1 XYZ June 65 call Long 1 XYZ June 70 call Net debit = $2.20 ($220 total) Maximum Profit The maximum profit for this long call condor spread is limited and would be seen if the underlying stock (or index) closes at or between the two middle, short call strike prices of $60 and $65 at expiration. The maximum profit amount is equal to the $5.00 strike price differential (difference in strike prices) $2.20 debit paid for the condor = $2.80, or $280 total. Maximum profit = $5.00 strike difference $2.20 debit paid = $2.80, or $280 total Maximum Loss At expiration, if the underlying stock (or index) closes at or below the lowest strike price of $55, or at or above the highest strike price of $70, the maximum loss for this long call condor would be limited to the net $2.20 debit paid for the spread, or $220 total. Maximum loss = $2.20 debit paid, or $220 total Break-Even Point At expiration, the upside break-even point for this long call condor would be a closing underlying stock price (or index level) equal to $70 (highest strike price) $2.20 (debit paid) = $ The downside break-even point would be with the underlying stock (or index) closing at $55 (lowest strike price) + $2.20 (debit paid) = $ Upside break-even point = $70 strike $2.20 debit paid = $67.80 Downside break-even point = $55 strike + $2.20 debit paid = $57.20

20 0 of 31 XYZ Price Long 55 Call Long XYZ June 55/60/65/70 Call Condor Paid $2.20 Net Debit = $220 Total Results at Expiration Short 60 Call Short 65 Call Long 70 Call of Spread Spread Profit/Loss* 75 + $2000 $1500 $ $500 0 $ $1500 $1000 $ $ $1400 $900 $ $100 $ $1280 $780 $ $ $1200 $700 $ $300 + $ $1000 $ $500 + $ $700 $ $500 + $ $ $500 + $ $ $300 + $ $ $ $ $100 $ $ $220 *Excluding commissions Assignment Risk Assignment on any Equity option or American-style index option can, by contract terms, occur at any time before expiration, although this generally occurs when the option is in-the-money. Equity Options For an equity call option, early assignment usually occurs under specific circumstances; such as when underlying shareholders are about to be paid a dividend. Assignment at that time might be expected when the dividend amount is greater than the time value in the call s premium, and notice of assignment may be received as late as the ex-dividend date.

21 21 of 31 If a long call condor spread holder is assigned early on in-the-money short calls, then he may exercise as many long calls and buy shares to fulfill the assignment obligation. If assigned on more short calls than in-the-money calls he is long, then he must either purchase underlying shares for delivery to fulfill his assignment obligation, or take a short position in those shares. American-Style Index Options If early assignment is received on in-the-money short calls of a long call condor spread, the cash settlement procedure for index options will create a debit in the investor s brokerage account equal to the cash settlement amount. This cash amount is determined at the end of the day the long call is exercised by its owner. After receiving assignment notification, usually the next business day, when the investor exercises his long calls the cash settlement amount credited to his account will be determined at the end of that day. There is a full day s market risk if the long option is not sold during the trading day assignment is received. If assigned on more short calls than in-the-money calls he is long, the cash settlement procedure will create a debit in the investor s brokerage account equal to the cash settlement amount. Long Put Condor General Nature & Characteristics The long put condor spread is made up entirely of put options on the same underlying stock (or index). It s constructed by purchasing one put with the lowest strike price, selling (writing) a put with a higher strike price, selling (writing) another put with an even higher strike price, and purchasing a put with the highest strike price. All puts have the same expiration month, and the increment between strike prices is the same. The ratio of long to short to short to long puts is always 1:1:1:1. The result is a position comprised of one long put (lowest strike), two short puts (2 middle strike prices) and one long put (highest strike). An investor with this position can be said to be long a put condor spread. Long put condor = buy 1 lowest-strike put + sell 1 higher-strike put + sell 1 even higher-strike put + buy 1 highest-strike put Note: One way to view a long put condor spread is as a long put butterfly with the two short puts one strike price apart. For this reason, you might see this spread referred to as a flat-top butterfly or an elongated butterfly. Debit vs. Credit A long put condor spread will always be established at a net debit. In other words, the amount of cash paid out for the two long puts (highest and lowest strikes) is more than the cash received for the two written puts (middle strikes). Long put condor = debit spread Example To establish a long put condor spread with XYZ options, an investor might buy 1 XYZ June 55 put for $0.35, sell 1 XYZ June 60 put for $1.75, sell 1 XYZ June 65 put for $4.30, and buy 1 XYZ June 70 put for $8.00. The result is the investor being long 1 XYZ June 55/60/65/70 put condor spread, at a $2.30 ( $ $ $4.30 $8.00) net debit. Long XYZ June 55/60/65/70 Put Condor

22 2 of 31 Action Quoted Price* Total Price* Buy 1 XYZ June 55 put - $ $35.00 Sell 1 XYZ June 60 put + $ $ Sell 1 XYZ June 65 put + $ $ Buy 1 XYZ June 70 put - $ $ Net Debit - $ $ *Excluding commissions Long XYZ June 55/60/65/70 Put Condor Long 1 XYZ June 55 put Short 1 XYZ June 60 put Short 1 XYZ June 65 put Long 1 XYZ June 70 put Expectation The long put condor spread is a neutral position. An investor employing this strategy is neutral on the underlying stock (or index), and expects it to stabilize between the two middle strike prices of the short puts until expiration. As well, the investor wants a decrease in option implied volatility that could enhance profitability before expiration, perhaps with even more of a move in theunderlying stock price (or index level) than expected. Long put condor: neutral Motivation for Spreading Just as a long put butterfly holder is neutral on the underlying stock, so is the holder of a long put condor. The buyer of a put condor, however, can see maximum profit over a range of closing underlying stock prices (or index levels) at expiration, instead of at a single strike price like the long put butterfly holder. Long put condor: increased chance of profitability Risk vs. Reward Maximum Profit The maximum profit for a long put condor spread is limited. This profit will be seen if the underlying stock (or index) closes at or between the two middle strike prices of the short puts at expiration. The maximum profit amount is equal to the strike price differential (difference in strike prices) less the debit paid for the condor. Maximum profit = limited (Underlying at/between 2 middle strikes at expiration) Maximum Loss The maximum loss for a long put condor spread is limited entirely to the net debit initially paid for it. This loss will be seen if the underlying stock (or index) closes at or below the lowest strike price, or at or above the highest strike price at expiration, no matter how high or low the underlying stock price (or index level) moves. Maximum loss = limited to debit paid (Underlying at/below lowest strike or at/above highest strike at expiration)

23 23 of 31 Break-Even Point There are two break-even points (BEPs) for a long put condor at expiration, one to the upside and one to the downside. The upside break-even point is a closing underlying stock price (or index level) equal to the highest strike price minus the debit initially paid for the spread. The downside break-even point, on the other hand, is equal to the lowest strike price plus the debit paid. Upside break-even point = highest strike price debit paid Downside break-even point = lowest strike price + debit paid Partial Profit At expiration, if the underlying stock (or index) closes at a point between the middle strike prices, and either the up- or downside break-even point, a partial profit would be seen. Profit & Loss Before Expiration Before expiration, an investor can take a profit or cut a loss by selling the spread if it has market value. This involves selling the long puts and buying the short puts, which will be done at a net credit, and these closing trades may be executed simultaneously in one spread transaction. Profit or loss would simply be the net difference between the debit initially paid for the spread and the credit received at its sale.

24 4 of 31 Effect of Volatility An increase in volatility has a negative effect on the long put condor; a decrease in volatility on the other hand has a positive effect. Effect of Time Decay Time decay has a positive effect on the long put condor, and this effect increases at a faster rate as expiration nears. Long Put Condor - Continued Example Long XYZ June 55/60/65/70 Put Condor Long 1 XYZ June 55 put Short 1 XYZ June 60 put Short 1 XYZ June 65 put Long 1 XYZ June 70 put Net debit = $2.30 ($230 total) Maximum Profit The maximum profit for this long put condor spread is limited and would be seen if the underlying stock (or index) closes at or between the two middle, short put strike prices of $60 and $65 at expiration. The maximum profit amount is equal to the $5.00 strike price differential (difference in strike prices) $2.30 debit paid for the condor = $2.70, or $270 total. Maximum profit = $5.00 strike difference $2.30 debit paid = $2.70, or $270 total Maximum Loss At expiration, if the underlying stock (or index) closes at or below the lowest strike price of $55, or at or above the highest strike price of $70, the maximum loss for this long put condor would be limited to the net $2.30 debit paid for the spread, or $230 total. Maximum loss = $2.30 debit paid, or $230 total Break-Even Point At expiration, the upside break-even point for this long put condor would be a closing underlying stock price (or index level) equal to $70 (highest strike price) $2.30 (debit paid) = $ The downside break-even point would be with the underlying stock (or index) closing at $55 (lowest strike price) + $2.30 (debit paid) = $ Upside break-even point = $70 strike $2.30 debit paid = $67.70 Downside break-even point = $55 strike + $2.30 debit paid = $57.30

25 5 of 31 XYZ Price Long 55 Put Long XYZ June 55/60/65/70 Put Condor Paid $2.30 Net Debit = $230 Total Results at Expiration Short 60 Put Short 65 Put Long 70 Put of Spread Spread Profit/Loss* $ $ $100 + $100 $ $230 + $ $300 + $300 + $ $500 + $500 + $ $300 + $800 + $500 + $ $500 + $ $500 + $ $200 $700 + $ $300 + $ $270 $770 + $ $ $400 $900 + $ $100 $ $500 $ $ $ $500 $1000 $ $ $230 *Excluding commissions Assignment Risk Assignment on any Equity option or American-style index option can, by contract terms, occur at any time before expiration, although this generally occurs when the option is in-the-money. Equity Options For an equity put option, early assignment generally occurs when the short put is deep in-the-money, expiration is relatively near, and its premium has little or no time value. If a long put condor spread holder is assigned early on in-the-money short puts, then he may exercise as many long puts and sell

26 26 of 31 shares purchased via the assignment obligation. If assigned on more short puts than in-the-money puts he is long, then he must purchase underlying shares. American-Style Index Options If early assignment is received on in-the-money short puts of a long put condor spread, the cash settlement procedure for index options will create a debit in the investor s brokerage account equal to the cash settlement amount. This cash amount is determined at the end of the day the long put is exercised by its owner. After receiving assignment notification, usually the next business day, when the investor exercises his long puts the cash settlement amount credited to his account will be determined at the end of that day. There is a full day s market risk if the long option is not sold during the trading day assignment is received. If assigned on more short puts than in-the-money puts he is long, the cash settlement procedure will create a debit in the investor s brokerage account equal to the cash settlement amount. Iron Condor General Nature & Characteristics A long synthetic, or iron, condor spread is made up of both call options and put options on the same underlying stock (or index). It s constructed by purchasing one put with the lowest strike price, selling one put with a higher strike price, selling one call with an even higher strike price, and purchasing one call with the highest strike price. All options have the same expiration month, and the increment between strike prices is the same. The ratio of long put to short put to short call to long call is always 1:1:1:1. The result is a position comprised of a long put (lowest strike), a short put (higher strike), a short call (even higher strike) and one long call (highest strike). An investor with this position can be said to be long (or hold) an iron condor spread, or long (hold) a synthetic condor spread. Long iron condor = buy 1 lowest-strike put + sell 1 higher-strike put + sell 1 even higher-strike call + buy 1 highest-strike call Note: There are two ways to view the composition of this iron condor spread. First, it is a short strangle (short call & put with two middle strikes), with the downside protected by a long put (lowest strike) and the upside protected by a long call (highest strike). Or second, it is constructed with two vertical spreads: a bull put spread (long lowest-strike put and short higher-strike put) and a bear call spread (long highest-strike call and short lower-strike call). Even though this spread is established at a net credit, it may be considered long because the profit & loss profile resembles a long call or long put condor. Debit vs. Credit A long iron condor spread constructed in the above manner will always be established at a net credit. In other words, the amount of cash paid out for the two long options (call & put) is less than the cash received for the two written options (call & put). Long iron condor = credit spread Example To establish a long iron condor spread with XYZ options, an investor might buy 1 XYZ June 55 put for $0.35, sell (write) 1 XYZ June 60 put for $1.75, sell (write) 1 XYZ June 65 call for $1.80, and buy 1 XYZ June 70 call for $0.50. The result is the investor being long 1 XYZ June 55/60/65/70 iron condor spread, at a $2.70 ( $ $ $1.80 $0.50) net credit. Long XYZ June 55/60/65/70 Iron Condor

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