Condor Options

We’ve had to adjust each of our three Calendar Options trades for June, and several readers have asked how we determine when to adjust a calendar spread. The basic answer is pretty straightforward, but first, let’s consider the question of why we adjust Calendar Options positions, when we’re always warning about the risks of adjusting iron condors.

When we construct our iron condor trades, we typically choose short strikes that are about one standard deviation away from the current price of the underlying; therefore, the probability of being in the money at expiration is only about 30%. However, the probability of being in the money at some point during the life of the trade is close to 60%. This means it’s more likely than not that we’ll be tempted to make an adjustment. But because the odds favor an out-of-the-money expiration, the adjustment usually turns out to be unnecessary.

A calendar spread, on the other hand, has a much lower probability of expiring with a profit if we just leave it alone. For a typical at-the-money calendar spread, the break-even points are only about ½ standard deviation from the strike, and the odds that the underlying price will end up between the break-even points at expiration are only about 30% to 35%. (In the figure at the left, the two vertical dotted lines closest to the center mark the break-even points; the outer vertical lines are at ±1 standard deviation from the center.) So why would we even want to enter such a trade? Two reasons: Risk/reward and adjustments.

Let’s say we paid $1.50/share for an at-the-money, one-month calendar spread approximately four weeks before the front-month expiration. If we were lucky enough to find the stock price exactly at our strike price on the final day of trading, our position would be worth about $2.70/share (assuming implied volatility has remained steady). That’s an 80% return in four weeks. Again, it’s very unlikely that this would happen, but if we disregard volatility risk (just to simplify the theory—we never would in real trading), we have the potential for $1.20 profit on a risk of just $1.50.

That’s great, you say, but it’ll never happen. Well, it could happen, but we don’t put on single calendars because we think we’ll hit the jackpot. We do, however, think there’s enough chance for the stock price to pass somewhere near the middle of the profit zone at some point two or three weeks after we enter the trade that we could get a quick 15% to 20% profit, especially if the implied volatility of the options goes up. Still, the odds of even this happening tend to be about 50-50—and that’s where adjustments come in.

Because calendar spreads yield such high profits if the underlying stays at the money, they can be used to shore up various kinds of positions, especially other calendar spreads. So if the stock moves past one of our break-even points (as is likely), we can slap on another calendar spread at the next higher or lower strike that’s nearest to the current price, and—voilà—we’ve turned a losing trade into an adjusted one that has a higher probability of success than our original position. (The figure at the right shows what the position described above would look like after adjustment if the underlying had risen to $113.15 one week into the trade.) Now, we do have to give up the chance for that 80% jackpot; but our odds of making a profit have increased from just over 30% to nearly 50%, and we have a good chance of ending up with at least a 10% return on our net cost. And, we can make additional adjustments if the stock continues to misbehave.

The above description of our adjustment strategy is a bit of an oversimplification, just to get the point across in a very direct way. Part II and Part III of this series of posts will explain in more detail exactly when and how we adjust our Calendar Options trades in practice.