Wednesday, September 8, 2010

Condor Evolution

In yesterday's post, I explored the role negative gamma plays in the evolution of a condor position. When displayed within a risk graph, it becomes readily apparent why condors thrive when mean-reversion drives market conditions. Yet another feature which helps explain a condor's frequent transformation from a non-directional to directional play is the inherent structure of the position.

The iron condor involves selling an out-of-the-money call and put spread simultaneously. Generally the deltas of each vertical spread offset each other bringing the net position delta close to neutral. In an ideal world, the stock would remain directly in between both spreads as time decay whittled away at their value. Both spreads may even approach their profit targets at similar speeds allowing you to exit the entire condor all at once. Unfortunately it rarely plays out this way in the real world. Typically the stock rises or declines affording the ability to close one side of the condor early - the put spread if the stock rises, the call spread if the stock falls.

Upon closing the winning side of the condor, trader's are left holding a directional vertical spread. When selling condors in a bullish trending market, they will likely turn into short call spreads before too long. On the other hand, when selling condors in a bearish trending market, they will likely turn into short put spreads.

In sum, though you may initiate a condor indifferent as to which way the market moves, you will quickly develop a directional bias due to the manner in which a condor changes its personality.

[Evolution Pic by Thomas Wizany]

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