Sometimes it is difficult to find the right option structure to express your point of view.
With so many different combinations and fancy names, it can be a challenge.
This article examines two very similar structures, the iron condor and the iron butterfly.
Both express a brief view of volatility, but there are a few small nuances that separate them.
In this article we will examine their similarities and differences.
Then we will practice evaluating which is the best.
A short one Iron condor is created by selling an Out of the Money (OTM) strangle and then buy another OTM choke (wing) as downward protection.
In contrast, an iron butterfly is created by selling an ATM (At the Money). spread Then buy another OTM-Strangle (see below).
If you look at these structures visually, they are quite similar. The structures express an almost identical view.
By placing this trade, we are conveying that we expect the underlying’s implied volatility to be overpriced.
Put simply, we think the stock will move less than the market expects.
To protect ourselves when we are wrong, we have also limited our losses.
This is from our long wings on either side of the heading.
Our exposure to the Greeks for both structures is initially as follows:
Delta Neutral, Short Gamma, Short Vega, Long Theta
Before this article delves into the differences and when to put one trading structure over another, it is important to emphasize that this is your view.
Imagine you are in a Turkish carpet marker. It is beneficial to know the nuisance of the fabrics and to haggle to get the best price.
However, doing so when you don’t even want a rug is a disadvantage.
You may be wearing a rug that you didn’t want at all.
The same goes for options. If we do not want to express the above view on volatility then we are simply not making any trade.
The first thing we notice visually is that the Iron Condor has a wider profit zone than the Iron Butterfly.
We have a much wider price range to get a full win on our balance when it expires.
In contrast, the Iron Butterfly initially has higher credit and therefore maximum profit.
If the supply is completely unchanged, the iron butterfly makes more than the iron condor.
However, reaching that maximum profit would literally mean the stock is pegged to the straddle price, which is very unlikely.
Neither of these are inherently better than the other.
Smaller, more frequent winners or larger, less frequent winners.
The expected value is the same.
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When the Iron Butterfly sells options for money, it has a higher one Vega exposure as the iron condor, at the beginning.
This means that something changes for each point implied volatility The Iron Butterfly will make or lose more money.
This is because changes in Vega affect ATM options the most.
This allows us to be more sensitive to the short vega we want to begin with. Conversely, we could sell more iron condors to get the same Vega exposure.
The downside to this is simple.
More contracts, more Commission and slip.
With an underlying asset under $ 20, an Iron Condor costs too much.
When you pay off a large part of your bankroll in commissions and slip-ups that eat right into your edge.
If you can get 20 cents in credit to make the trade, you will likely need to avoid trading the underlying asset or switch to a straight short straddle.
* Note: If the underlying price moves, the Vega will change.
For example, if the price moves outside of our wings, we can actually become a long vega.
Sometimes liquidity may be better for either the ATM or light OTM strikes.
Popular round number strikes (e.g. 100) have higher liquidity and an open interest than other numbers (e.g. 99).
This isn’t a huge problem for the most popular stocks, but it can be a problem for smaller illiquid option chains.
Often times, even if you think there is liquidity when you enter a trade, it seems to go immediately when you have to exit.
By choosing higher volume strikes, you can help keep yourself out of a market maker and get a fairer fill.
While we generally want to act directionless, sometimes it is difficult to act without direction.
This is especially true when we are trading an iron butterfly.
If the underlying is trading somewhere in the middle of different strikes, we don’t have to pick one and take it over delta at the start.
This is particularly relevant in trading shorter duration since the delta we have at the beginning can be significant.
If we want that directional view, then it’s a perfect trade.
If not, it is better to edit your Iron Condor body so that you can get it as close to delta neutrality as possible.
Using an example.
I took a screenshot of the weekly options for Ford stock.
Should we choose an iron condor (in yellow) or an iron butterfly (in green) here?
The answer is clearly the Iron Butterfly.
If we choose the Iron Condor, we only get 35 cents of credit minus the cost of our wings. Ouch!
If you didn’t think so, you’re right.
A Short straddle would be much better than an iron fly due to the low price of the underlying asset and the short days to expire.
It’s very unlikely that Ford will climb to $ 11 or $ 16 by the time it expires.
The contracts are traded for a few cents (shown in red).
Therefore, the short straddle minimizes transaction costs while maximizing the funds that we keep to ourselves.
Let’s look at another example. I went to Tesla Options.
Should we put an iron condor or an iron butterfly here?
First of all, we can see that the price is trading at $ 693.20.
If we want to do Iron Butterfly right off the bat, we have to choose either the 695 or the 690 beat.
The 695 strike is closer to the ATM. So if we’re ready to bullish lean a few deltas, we could ride the Iron Butterfly with the body at 695.
The spreads are very tight on the call side, but less so on the put side.
Though we have a decent open interest on the put side.
Alternatively, we could do an Iron Condor with a body of 690/695 which is also very close to Delta Neutrality. We could also pick the 685/700 strikes.
The 700 call has a lot of open interest, the 685 put not that much. But the spreads are tight.
Here we have an example of 3 possible choices.
Neither is right nor wrong.
In many cases we will choose between apples and other apples. For this example, I would say it is up to your preference whether you are doing an Iron Condor or an Iron Butterfly.
Choosing the right option structure can be challenging.
The Iron Condor and the Iron Butterfly offer almost identical exposures.
Both are risk-defined trades with short volatility.
The choice between the two can often be due to the price of the underlying asset and the available strikes.
With larger liquid stocks, the final decision can often depend on personal preference or direction.
Are you more inclined to take higher odds or higher risk to reward the trade?
If executed correctly, any trade can ultimately be profitable if the realized volatility is less than the market implies.
Disclaimer: The information above applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.