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.)
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