QUESTION: How do you short a stock if you missed an initial move and it is liable to snap back?
ANSWER: Execute an unbalanced condor
By now everyone has witnessed the chaos surrounding the most hyped initial public offering (IPO) in years — Facebook (FB). The stock opened Wednesday, May 23 at $38. A few overzealous people bought it up to $45, only to watch it fall $10 below its IPO price one week later. There are many responsible for the debacle, including the underwriters, the founders, the exchange and people pinning their hopes on a home-run.
Much of the selling can be attributed to people long the stock from the IPO who closed out to lick their wounds. Yet many analysts place FB’s true value much lower and it risks going down even further. The other side of the coin is that it already has dropped significantly and some may see value.
We were critical of the IPO well before the event, but we don’t like making naked bets and had to wait until options were available. FB options began trading on Tuesday, May 29 and that is the first time we started looking at positions. So the question remains, “How to take a short position to ride the trend without getting hurt if the stock snaps higher?”
Enter the unbalanced condor.
A traditional condor is the simultaneous purchase of a vertical put (or call) spread and the sale of a further out-of-the-money put (or call) spread with the same expiration and contract quantities. These spreads are very similar to butterflies but have the vertical spreads further apart, and usually require more of a capital outlay.
An unbalanced condor is the simultaneous purchase of a vertical put (or call) spread and the sale of a further out-of-the-money put (or call) spread using more contracts. The extra vertical sales are designed to coordinate a balance because you are adding slightly more risk but also taking debit out of the trade.
The table below shows the difference between the two condors. The “probability” column in the middle shows the probability of each strike going in-the-money on expiration (based on 51 days to expiration, 63% implied volatility and stock at $28.18). For example, the odds of the stock falling from the current price of $28.18 to $22 by the July 20 expiration are 17%.
The traditional condor will cost the buyer of this spread 20¢ a share, or $200 on 10 contracts. Because the spread is long 10 contracts of a $1 (27-26 strike) put spread, the most that can be made is a net of $800 ($1,000—$200 debit). Investing $200 on something that can return $800 usually is prudent, especially considering the risk in a naked position — the owners of 500 shares of FB currently are down roughly $5,000 — but we missed the initial sell-off and don’t want to risk a loss if the move stalls.
Meanwhile, the cost of the unbalanced condor is zero because of the extra spreads sold. Yes, there is a slightly higher level of risk, but the odds remain in our favor, and at no cost.
Would you rather lose $200 on the traditional condor should the stock remain flat, fall a little or run higher, or would you rather lose nothing under the same circumstances with the unbalanced condor — but have $1,000 of risk should a small statistical event occur?
“Getting in for free” shows the break-even graph of this spread on expiration day (when there is no time value left in the options).
The graph shows a comparison between the traditional condor and the unbalanced. You will notice that, all the way down to roughly $21.50, the unbalanced condor greatly outperforms the traditional condor, as long as you are not concerned about the stock falling another 23.7% in the next few weeks. Again, you are trading a small additional risk that can occur only about 17% of the time for a greatly lower entry cost.
The spread also can be done with calls to orchestrate a bullish position for those believing that the stock has hit a bottom.
J.L. Lord is an analyst and author of many articles for RandomWalkTrading.com.