The market has pulled back some in recent days, but as of this writing the S&P 500 is still trading near record highs. Yet with the market rally fueled by the Fed cutting interest rates (rather than strong fundamentals) and some weak earnings being reported by Wall Street’s darling tech companies, which suggests that investors have baked in overly expectations into the stock market, it almost feels like the other shoe is about to drop.

When high volatility is expected, one way to protect oneself is to use options. Today I will discuss a specific strategy called the short condor spread, which is used when high volatility is expected. This is only one of many different option strategies you could deploy.

Short Condor Spread

The strategy is a little bit complicated because it contains four options. The options will have the same expiration date but four different strike prices. You write (i.e., short sell) the options with the highest and lowest strike prices and you buy the options with the middle strike prices.

Note that if you expected low volatility, then a long condor spread would make sense. The difference is you would buy the options with the highest and lowest prices and write the options with the middle strike prices.

Typically, you want to keep the distance between each strike price the same—for example, a difference of $1 between each option. However, you can adjust the spread as you see fit.

Let’s use an example with a real option, the February Barrick Gold (NYSE: GOLD) calls, which trades around $19. Puts would work similarly but for our example we are using calls.

Here are the four legs of the spread (using actual market prices as of this writing):

Sell the February 2025 $18 call for $2.39
Buy the February 2025 $19 call for $1.80
Buy the February 2025 $20 call for $1.32
Sell the February 2025 $21 call for $0.99

You have a credit of $3.38 ($2.39 + $0.99) and a debit of $3.12 ($1.80 + $1.32). You have a net credit of $26 ($0.26 x 100) if you traded one contract per leg. And let’s say you traded five contracts per leg, the net credit would be $130. That would also be your maximum potential gain, which occurs when the stock price ends up above the highest strike price or below the lowest strike price.

Keep in mind that I am trying to keep the example simple, so don’t worry if the maximum gain seems small. Also note that the example shows the returns if you held the options to expiration. You can close out any leg of the condor spread at any time before expiration so it’s possible to make a lot more.

Breaking Things Down

If GOLD ends up below $18, all the options will expire worthless and you keep the net credit.

If GOLD ends up above $21, the options will cancel each other out. Let’s say GOLD ends up at $22 at the expiration date of the options, your gain/loss on each leg of the option (without considering the premium) would be:

• The 18 call: -$4
• The 19 call: +$3
• The 20 call: +$2
• The 21 call: -$1

The gain and loss here cancels each other out, leaving only the net credit as the profit.

A loss could occur if GOLD ends up between $19 and $20. Your maximum loss would be $74 if you traded one contract per leg.

More than One Breakeven Points

The chart shows the profit/loss if all four option positions are held to expiration. Notice that there is are two breakeven points: upper and lower. The upper breakeven point is the highest strike price minus the net credit. So this would occur when the stock ends up at $20.74 ($21 – $0.26). The lower one is the lowest strike price plus the net credit received. So this would occur at $18.26 ($18 + $0.26).

In other words, if GOLD ended up at lower than $18.26 or higher than $20.74 at expiration, you will end up with a profit. Now do you see why a short condor spread works best when volatility is high?

High volatility means large price swings, so the price is more likely to end up outside of that range of $18.26 to $20.74.

In our example, due to the pricing of the legs of the spread, the maximum potential upside is small compared to your maximum potential loss. And if you included commissions, you would be left with an even smaller profit.

To get around this, you could trade more contracts for each leg. For options, brokers typically charge one fixed fee plus a smaller variable fee based on how many contracts you trade, so if you traded more contracts you would lower the average commission cost.

Be Flexible

The chart only reflects what happens if you initiated the trade and just let all four contracts expire. In real life you are not required to hold all options to expiration.

For example, if GOLD falls to $17 and looks like it might keep falling, you could close out the two long call positions before their values fell to zero, and you can let the short call options expire. In reality you could end up making a larger profit than what we calculate above.

If you think something is about to jolt the stock, causing large price swings, that’s the time to do a short condor spread. It’s also an advanced strategy, so you may want to learn a little more about option trading before you try to execute such a trade.

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