Question: How can you profit from a potentially strong bull move while protecting yourself from a second bear wave?
Answer: A ratio condor
Can anyone think of a good reason to throw caution to the wind and go long equities? Listening to the "experts" can leave you feeling fear and trepidation, even when the market is advancing. The only ones making serious money (without losing sleep) in recessions are psychiatrists prescribing Xanax.
The media is constantly comparing this recession to the Great Depression; however, this recession is not that far from the mean of other recessions when measured by unemployment, duration and GDP. For example, unemployment was higher (10.8%) in the 1981-82 recession. If you combined that with the shorter 1980 recession, it was longer in duration, too (see "The Great Depression and after," below). There are plenty of reasons to be bullish:
- The markets can’t seem to sell off, even on bad news.
- The markets are up an average of 8.9% on a normal year, but are up an average of over 27% during a post mid-term year.
- Historically, the best market advance was 44% (280.90 to 404.39). This happened in 1954 when we were in a recession.
- The worst part of our current recession involving banking, foreclosures and unemployment appears to be behind us.
Even an optimist can find it emotionally difficult to be long a market under these circumstances. And to be fair, the depth of the economic downturn must be measured against the extraordinary interventions undertaken (TARP, quantitative easing, extended zero rate policy, etc.) to prevent an all out depression. The bottom line is there are many very smart people who believe the worst is yet to come even though this is historically a good time to get long. The answer to that dilemma may be the ratio condor, which allows you to profit from your bullish bias and sleep at night.
In this strategy, we sell a vertical call spread to receive a premium that we can use to purchase a wider vertical call spread with extra units to provide maximum profit potential. With the ratio condor, we trade the wide range of loss potential with a tighter range of loss. In this example, the position only loses money if the index does not move outside of a tight range after two months.
Using options on the Dow Jones Index (DJX) for simplicity, we can sell a slightly in-the-money vertical to pay for the purchase of a slightly out-of-the-money vertical, which is wider and has more units. With the DJX at 110.63 ( the Dow being at 11,063), we can use the following 60-day option chain to do two things:
- Part A — Sell 10 contracts of the DJX December 111-113 call spread at $0.96, and
- Part B — Buy 12 contracts of the DJX December 114-117 call spread for $0.82.
This trade will be done for a net 24¢ debit, or a total dollar debit of $24 before commissions (see "Putting on the trade," below). You will notice from "Home on the profit range" (below) that the PNL graph shows this is an excellent solution. You can be long a market that you believe will go higher, while remaining very protected on the downside. We win the battle of mind over emotions while setting ourselves up to make a decent profit.
A "ratio condor" (aka unbalanced condor) is a strategy designed to profit from the upside potential you are expecting while protecting your downside. It will allow you to sleep at night, even with fears of the floor dropping out at any time.
It can be initiated with a bearish stance simply by reversing the process and utilizing put options instead of call options.
Edward LaPorte is an advisor to Random Walk, which designs options education material at RandomWalkTrading.com.