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February 4, 2010

COST Short Iron Condor

Filed under: Uncategorized — Tags: , , , , — Dan Passarelli @ 10:30 am

In last week’s edition of the Market Taker Edge newsletter, we took a look at a short iron condor on Costco Wholesale (COST) [Which is proving to be a nice little trade, BTW]. One of the rationales behind selling the March 50/52.50/60/62.50 iron condor was that COST’s implied volatility (implied volatility is – simply defined – the volatility component of an option price) were inflated to roughly 22% (meaning the implied volatility has pushed the option price higher) , which lifts the premium values for option sellers. In addition, the profitable range on the short iron condor is $51.90 to $60.60.

Before we delve any further into the trade, let’s take a look at the strategy. A short condor occurs when a trader combines a bear call spread and a bull put spread. The trade is executed by buying a lower-strike out-of-the-money put and selling an out-of-the-money put with a higher strike. Then the trader sells an out-of-the-money call with a higher strike and buys another out-of-the-money call with an even higher strike.

A short iron condor consists of four legs and results in a net credit received.  As for profit potential, the maximum potential profit is the initial credit received upon entering the trade. This profit will occur if the underlying stock price, on expiration date, is between the two middle (short) strikes. As noted before, the max potential profit for the COST trade would occur it the stock was trading between $52.50 and $60 by expiration.

One of the benefits of a short iron condor (and potentially options in general) is limited risk. For short condors, the maximum loss comes when the underlying stock price drops below the lowest strike or above the highest strike. If you want an equation for max loss, think of it as the difference in strike prices of the two lower-strike options (or the two higher-strike options) less the initial credit for entering the trade. In the case of COST, the max potential loss was limited to $1.90. Not bad, right?

Well, we now have to look at the stock and the aforementioned rationale to the trade. COST is a warehouse retailer, allowing customers to pay for membership and then purchase any of their daily needs (and sometimes wants) at a bulk discount. Retail has struggled thanks to the recession and all, but COST has traded in a range between $51.90 and $60.60 (the aforementioned profitable range on this trade) since September. With the market kicking sideways, expect COST to do the same – making this trade strategy ideal for the current market.

It’s best to take profits when able on this short iron condor, mainly because the company posts earnings on March 4. This date would be ideal to exit the trade by because this event has a chance of pushing the COST out of its range. Again, we suggested this trade in our newsletter, the Market Taker Edge, because COST has such a wide profit range and a potential return on risk of roughly 32%. The short iron condor is a logical way to play COST in this scenario.

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