There are many reasons to consider trading options. One use is to obtain leverage when making a directional play. Another is to hedge an existing position. One other use is to take advantage of opportunities that are simply not available to those who only trade the underlying stock, index or futures security. This last possibility typically involves the use of option spreads whereby one option or set of options is sold while another option or set of options is bought. One approach to above-average probability spread trading that is relatively new to the mainstream is known as the "modidor," which is a modified version of a popular strategy typically know as the "iron condor."

The Starting Point: The Iron Condor
As a quick review, an iron condor involves selling an out-of-the-money call and an out-of-the-money put option while simultaneously buying a further out-of-the-money call and put. In a "classic" iron condor the options sold are a roughly equal distance from the underlying price. Likewise, the difference in the strike prices between the two call options is the same as the difference between the strike prices for the two put options. Ideally, an iron condor will be entered when the implied volatility of the options is high. High implied volatility indicates that there is an above-average time premium built into the price of the options, allowing a trader to maximize his or her profit potential by taking in as much premium as possible.

By putting on this position, a trader establishes a range of profitability as long as the underlying security stays within a particular range prior to option expiration. While profit potential is limited to the net credit received when entering the trade, the trader's maximum risk is also limited. Figure 1 displays the risk curves for a typical iron condor. (For more information regarding iron condors, check out Take Flight With An Iron Condor, Should You Flock To Iron Condors? and Iron Condors: Wing It To Maximum Profit.)

Figure 1: Risk curves for an iron condor
Source: Optionetics Platinum

One key thing to note in Figure 1 is that the trade has two breakeven prices - one above the current price and one below. This trade will make money if the price of the underlying security remains between the two breakeven prices but will lose money if the underlying security moves too far in price in either direction.

In this example, the maximum profit potential is $365, which would be realized at expiration if the underlying security is trading between the strike prices of the call and put that were sold. The trade will generate some profit as long as the underlying is trading between the two breakeven prices of 106.27 on the downside and 134.73 on the upside.

The ideal setup for an iron condor is an underlying security that is relatively quiet and locked into a trading range. Whether that is or is not the case for the security in Figure 1 is somewhat in the eye of the beholder. The security had been trending higher but now is in the middle of a two-month trading range with clearly identified support and resistance levels. (Discover how these influential levels can switch roles. Check out Support and Resistance Reversals.)

The Modified Iron Condor (the Modidor)
The risk curves for a modidor using options on the same security that appears in Figure 1 is shown in Figure 2. The trade shown in Figure 1 sold a call and put both roughly 13 points out-of-the-money and then "bought the wings" (i.e., a higher strike call and a lower strike put) another three points out-of-the-money). The trade in Figure 2 takes a different approach. With the underlying stock trading at $123 a share, this trade sells the 130 strike price call and buys the 131 strike price call. On the put side, this trade sells the 115 strike price put and buys the 110 strike price put.

To put it another way, the trade:

  • Sold a call seven points out-of-the-money and sold a put eight points out-of-the-money
  • Bought a call one point above the call option sold
  • Bought a put five points below the put option sold

The net effect of these variations is to change the configuration of the risk curves, which appear in Figure 2.

Figure 2: Risk Curves for a Modidor
Source: Optionetics Platinum

The primary advantage of a modidor is that there is only one breakeven price, thus the underlying security only has to stay above (in the case of a bullish modidor, or below in the case of a bearish modidor) a particular breakeven price in order for the trade to show a profit, rather than having to remain in between two breakeven prices. In this example, while the underlying stock is trading at 123 a share, the breakeven price of the trade is 113.78. This illustrates how a trader might use a modidor to increase the probability of profit versus an iron condor.

The key areas of note on this example trade are:

  • The underlying security is trading at $123 a share.
  • The breakeven price is $113.78. If the underlying security does anything other than decline by 7.5% or more over the 46 days between the time the trade was entered and option expiration, this trade will show a profit.
  • If the underlying security is between the strike price of the options sold (115 put and 130 call) at expiration, the maximum profit potential is realized as all options expire worthless.
  • If the underlying security moves above the strike price of the call option sold (130 strike price) profit potential is limited but most importantly still positive.
  • The maximum loss potential would only be realized if the options were held until expiration and at that time the stock was trading below the strike price of the put that was purchased (i.e., the 110 strike price put).

The Bottom Line
Option trading allows traders to take advantage of unique situations which are typically not available to those who trade only the underlying stock or futures contract. In addition to "standard" strategies such as the iron condor, an alert trader can also consider using alternative strategies such as the modidor spread to put the odds more firmly in his or her favor. (For more option strategy ideas read An Alternative Covered Call Option Trading Strategy.)

Related Articles
  1. Investing Basics

    5 Things to "Deliberately" Do to Improve Your Trading

    Most traders are putting in trading hours, but not improving. Here are deliberate steps that can take your trading to the next level.
  2. Technical Indicators

    Using Moving Averages To Trade The Volatility Index (VIX)

    VIX moving averages smooth out the natural choppiness of the indicator, letting traders and market timers access reliable sentiment and volatility data.
  3. Fundamental Analysis

    Is India the Next Emerging Markets Superstar?

    With a shift towards manufacturing and services, India could be the next emerging market superstar. Here, we provide a detailed breakdown of its GDP.
  4. Term

    Estimating with Subjective Probability

    Subjective probability is someone’s estimation that an event will occur.
  5. Home & Auto

    When Getting a Rent-to-Own Car Makes Sense

    If your credit is bad, rent-to-own may be a better way to purchase a car than taking out a subprime loan – or it may not be. Get out your calculator.
  6. Investing Basics

    Understanding the Modigliani-Miller Theorem

    The Modigliani-Miller (M&M) theorem is used in financial and economic studies to analyze the value of a firm, such as a business or a corporation.
  7. Economics

    Explaining Kurtosis

    Kurtosis describes the distribution of data around an average.
  8. Investing Basics

    Explaining Forward Rate Agreements

    Forward rate agreement (FRA) refers to an interest rate or foreign exchange hedging strategy.
  9. Personal Finance

    Simple Interest Loans: Do They Exist?

    Yes, they do. Here is what they are – and how to use them to your advantage.
  10. Options & Futures

    An Introduction To Value at Risk (VAR)

    Volatility is not the only way to measure risk. Learn about the "new science of risk management".
  1. Security

    A financial instrument that represents an ownership position ...
  2. Series 6

    A securities license entitling the holder to register as a limited ...
  3. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  4. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
  5. Board Of Directors - B Of D

    A group of individuals that are elected as, or elected to act ...
  6. Financial Singularity

    A financial singularity is the point at which investment decisions ...
  1. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  2. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  3. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  4. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>
  5. What does a futures contract cost?

    The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>
  6. What are common delta hedging strategies?

    The term delta refers to the change in price of an underlying stock or exchange-traded fund (ETF) as compared to the corresponding ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!