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Option Tip – Monday, November 14, 2011
SPY Iron Condors



The Option Tip to Exploit Elevated Volatility using Iron Condors with SPY

This strategy provides income and protection for a market that’s on the move!



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spy heading

The problems stemming from the Eurozone continue to hang ominously over the global stock market.

While October saw an increase in buying that bolstered equity prices and returned us to more of a normal trending state, Wednesday’s market sell-off was a painful reminder that we’re not out of the woods yet.

Not surprisingly, the massacre was accompanied by a notable surge in panic as demand for option protection soared which leads us to this option tip. The CBOE Volatility Index (CBOE: VIX) rose an impressive 31.5%, vaulting from 27 to 36. The last two times the VIX reached these heights, the advance was rebuffed — signaling a golden opportunity to enter short volatility plays. Such an opportunity may be in the cards yet again.

VIX-111411-one week



This option tip encompasses the common play of choice for traders looking to exploit elevated option premiums, which is the iron condor. Though it is a four-legged position and perhaps a bit intimidating at first glance, it’s actually a fairly straightforward strategy.

An Iron Condor, is an advanced option strategy that is favored by traders who desire consistent returns and do not want to spend an inordinate amount of time preparing and executing trades. As a neutral position, it can provide a high probability of return for those who have learned to execute it correctly.

iron condor

An Iron Condor is an advanced options strategy that involves buying and holding four different options with different strike prices. The iron condor is constructed by holding a long and short positions in two different strangle strategies. A strangle is created by buying or selling a call option and a put option with different strike prices, but the same expiration date. However, the potential for profit or loss is limited in this strategy because an offsetting strangle is positioned around the two options that make up the strangle at the middle strike prices.

This strategy is mainly used when a trader has a neutral outlook on the movement of the underlying security from which the options are derived. An iron condor is very similar in structure to an iron butterfly, but the two options located in the center of the pattern do not have the same strike prices. Having a strangle at the two middle strike prices widens the area for profit, but also lowers the profit potential.



Think of it as exactly what it is: two spread trades on the same underlying asset. Best of all, both of them pay you right away! An iron condor involves simultaneously entering an out-of-the-money bull-put spread and an out-of-the-money bear-call spread. The strategy is designed to profit as long as the market remains between the short strikes of either spread.

With implied volatility as high as it is, the options market is pricing in huge movement over the coming month which favors this option tip. By entering an iron condor, we’re expressing our opinion that the market will NOT move as much as is currently priced in.

SPY-111411



The SPDR S&P 500 ETF Movements in the Past Week

The Spyder Trust (SPY) dropped down to test daily trend line support on Wednesday in the $122.78 area before turning higher at the end of the week.

Helping construct this option tip was the movement during the past week. The close on Friday was just below the upper boundary of the flag formation.

A close above $128.15 will complete the formation with initial targets at $131.50. There are additional upside targets in the $136 area.

The S&P 500 A/D line has turned up sharply, and is not far below the July highs, when SPY was trading in the $134-$135 area. It would now take a drop below the early November lows to weaken it.

If last week’s lows at $122.86 were broken, the next level to watch is the 38.2% Fibonacci retracement support at $121.02.

The Option Tip

With the SPDR S&P 500 ETF (NYSE:SPY) currently trading at $126.66, we could enter an iron condor by selling the following two spreads:

1. December Bear-Call Spread: Sell to open the SPY Dec 133 Call for $0.70 while buying to open the SPY Dec 138 Call for $0.14. The net credit received on this part of the trade is $0.56.

2. December Bull-Put Spread: Sell to open the SPY Dec 110 Put for $1.47 while buying to open the SPY Dec 105 Put for $0.97. The net credit received on this part of the trade is $0.50.

T/he total credit received for the iron condor is $1.06 ($0.56 + $0.50), which represents the maximum potential reward. The max risk is the width of the spread ($138 strike – $133 strike, or $110 strike – $105 strike = $5) minus the net credit ($5 – $1.06 = $3.94).

Provided the SPY remains between $133 and $110 by December expiration, the iron condor will come out a winner. This option tip relies on the fact that the SPY would have to rise more than 9% or fall more than 11% in about five weeks for the trade to be a loser at expiration.

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