A How-to Guide: The Iron Butterfly & Other Option Spread Strategies
By their names, these options strategies sound intriguing. Iron Butterfly. Iron Condor. Most investors, regardless of skill level, probably don't what these options strategies are about, but they are among the most useful for making during sideways markets, that is the market's less volatile periods. And that trait, more so than their names, makes bottom lineon butterflies and condors unique because many of the options strategies we have discussed previously are based on volatility.
Let's face it, if you're a semi-active investor a range-bound market can be downright boring. Not to mention fairly difficult to profit in. Well, for every season, there's an outfit, and for every market, there's a way to profit. In a market that acts choppy for an extended period of time, iron butterflies and condors can become the option investors’ best friend.
Like a bear call or bull put, butterflies and condors are multi-legged, income generating trades. In fact, the long iron butterfly is a combination of bear call spread and bull put spread. That gives us a trade with four parts instead of two and trade that needs to be paid attention, so butterflies are probably best left to an options investor with at least some experience.
Let's examine what it takes to build a profitable iron buttefly and condor.
Let's start with a long iron butterfly, which we noted earlier is a combination of a bear call and bull put spreads. Since there are four options being used with a long iron butterfly, the dream scenario is that they all expire worthless. As this is an income trade, our downside risk is limited, but so is our profit potential.
To initiate the trade, we would buy one out of the money put with a lower strike price than the at the money put we'll be selling. Consider that action steps 1 and 2. Next, we'll sell an at the money call and buy a call with a higher strike price that is out of the money. Consider those moves steps 3 and 4. Two things of importance with long iron butterflies: You MUST buy both puts and calls and ALL of the options purchased must share the same expiration date. Also note that the short call and short put should share the same strike price.
Let's illustrate a proper long iron butterfly. We want to use XYZ Inc. as our stock. The shares are trading at $30 in March. So we buy the April $25 puts for $1. Then we'd sell the April $30 puts for $5. Next, we're selling the April $25 calls for $6 and buying the April $30 calls for $2. We bought two positions that cost a combined $3 and sold two for a combined $11 so our credit is $8, which in reality is $800 ($8 x 100 shares = $800). That credit is probably a little high as we're the prices used in this example, but you get the picture.
Like the bear call and bull put spreads, this is a short-term trade where time decay is our friend as long as the trade is profitable. The long iron butterfly isn't meant to be held to expiration. Traders can exit the position one leg at a time, which a more advanced trader may do, or all at once.
Although the condor and the butterfly share no similarities in the animal kingdom beyond that they both have wings, they're a little more closely related in the options world. As with the iron butterfly, the iron condor requriaes four different options to initiate. And believe it or not, the long iron condor is also a combination of a bull put spread and a bear call spread.
The key difference is that all four legs of the bion condor when added should be out of the money. This means we're going to buy an out of the money put and sell an out of the money put at a higher strike price. Again, this represents steps 1 and 2. Next, we'll sell an out of the money call and buy a call with a higher strike price. All the contracts should have the same expiration date and the short put's strike price needs to be lower than the short call's strike price.
Alright, here's what a long iron condor looks like. Let's suppose XYZ is trading at $37 in June. We would buy the July $30 puts for 50 cents. Then we'd sell the $35 puts for $1.50. Next we'd sell the $40 calls for $2 and buy the $45 calls for 30 cents. So we've sold $3.50 in positions and bought 80 cents worth for a net credit of $2.70 (or $270 in “real life.”) The net credit is our maximum reward while the most we can lose is the difference between the all the strikes combined and the net credit.
It's worth noting that while we keep using XYZ stock as an example, iron condors can be used on indices, futures, and exchange-traded funds (ETFs). In fact, iron condor index options are the favorite choice of many advanced options traders. And of the course, iron condors benefit investors with lower portfolio volatility, reduced bias and, best of all, income.
The Odds Are In Your Favor
One of the reasons that so many investors turn to iron condors is that the odds, for once, are in our favor. If one side of the trade goes against, the flexibility of condors allows us to alter the trade back into a bear call or bull put spread. Being flexible in the case of iron condors can result in being right and collecting income. Is there a better feeling?