Where investing is concerned, there are two basic forces that compete with one another: risk versus reward. Investments with increased risk naturally tend to have higher odds for large profits, and vice versa. Striking the right balance between risk and profit potential is a constant challenge for investors as each person has their own comfort level. Options represent contracts granting holders the right to buy or sell 100 shares of an underlying stock (which may also be a commodity, index, or another financial vehicle) and are considered an important investment tool that help investors manage risk and reward. In fact, many investors see options as a great way to hedge against potential losses while maximizing the potential for profit.
An option does not represent 100 actual shares of the underlying stock – it is merely the right (but not the obligation) to buy or sell 100 shares of stock should the market value match or exceed the strike price of the option (the strike price was determined at the time the option was written). A call option is considered to be “in-the-money” when the market price of the stock exceeds the strike price. A put option is considered to be “in-the-money” when the market price is below the strike price – at the time of expiration. If the option is not “in-the-money” at the time of expiration, then the option is worthless and the investor loses all the money that was paid, including the premium and commissions.
Buying an option can sometimes be a way to limit your total loss while still preserving the potential for unlimited profit. However, the “buy condor” stock option investment strategy minimizes the total loss while also limiting total profits. Investors should consider using the buy condor option strategy when they believe there will be volatility in the stock price – but only within a set range. When using the buy condor strategy, an investor will buy an option with a low strike price and pay a high premium. The investor will also sell two options with two different middle strike prices. The middle strike prices will be split and the investor will receive a premium (of varying amounts) for each option sold. Finally, another option is purchased with a higher strike price. The “set range” mentioned earlier is the difference between the high and low strike prices.
For instance, an investor using the buy condor option strategy might buy a low call option with strike price of $40 (low strike) and another with a strike price of $60 (high strike). Then, the investor would sell two options with middle strike prices (the middle strike price would be $50, so the two options sold would have strike prices of $45 and $55 as these are the midpoints between the low and high strikes) and receive a premium for each sale. Maximum loss is limited to the total cost of buying and selling the options (premiums received minus those paid minus all commissions) and is reached when the market price is above the high strike or below the low strike price at expiration date. Maximum profit is reached when market price settles at the midpoint between the medium strike amounts ($50 in our example).