It’s time to start a new Real-World Trading series and it’s been suggested that I look at an Iron Butterfly. I know this sounds complicated and that you might be a bit intimidated at first, but trust me—the strategy is actually pretty easy to learn and implement. Before we go into the details about how to place an iron butterfly trade, let’s discuss the basics of neutral trading strategies.
There often are times when a stock or a market moves in a range-bound motion. This means that there is consistent resistance overhead and similar support underneath the security. This doesn’t mean the stock won’t move up and down, just that the movement will be in a range. During these time periods, stock traders get frustrated, as they can’t sell short to make money, nor are they profiting to the upside. But, option traders can profit when a stock stays in a range.
There are several strategies that benefit from sideways movement, including calendar spreads, credit spreads, butterflies and condors. An iron butterfly has the same risk graph as a condor, but the set-up is just slightly different. Let’s examine what a condor is and then we’ll discuss what is different about an iron butterfly.
A condor is a neutral trading strategy that uses the combination of four options to create a trade that profits if the underlying security stays within a determined range. For example, let’s say that XYZ stock has been trading between 50 and 65 for months, with the stock staying between 55 and 60 for a majority of the time. What we would want to do is create a strategy that profits if XYZ closes between 55 and 60 at expiration. In this case, a condor would look like this:
Buy 50 Call (Put)
Sell 55 Call (Put)
Sell 60 Call (Put)
Buy 65 Call (Put)
Since the two sold options are closer to the price of the stock than the wings of the trade, we would take in a credit using this strategy. In fact, if the stock does close at expiration between 55 and 60, we would achieve our max profit. The max risk is figured by taking the difference in strikes—which in this case is 5 points—and subtracting the credit received. Therefore, if we received a credit of 2 points, then our max risk would be 3 points.
The risk graph for a condor and iron butterfly looks like the chart below:
Notice how our profit zone is wide, allowing for some play in the stock while still getting the max profit. At the same time, our max risk is capped so that we know ahead of time what the risk is and can decide on whether the possible reward is worth the risk.
Now, some of you might be asking if it is better to use puts or calls when using a condor. Good question and one that helps me segue to an iron condor. When using a regular condor trade, we would want to look at the risk/reward for the puts and the calls to see which one works the best. However, we would also want to check to see if we should use calls on the upper half of the trade and puts on the lower. If the risk/reward is best using a combination of puts and calls, then we have an iron butterfly. Below is an overview of an iron butterfly trade:
Strategy: Buy one higher-strike call. Sell one lower-strike call. Sell one higher-strike put. Buy one lower-strike put.
Time Decay Effect: Mixed
Situation: Look for a sideways market that you expect to close between the wings of the iron butterfly.
Profit: Limited to the net credit received.
Risk: Limited (difference between long and short strikes times value per points, minus net credit received).
Upside Break-even: Strike price of middle short call plus the net credit received.
Downside Break-even: Strike price of middle short put minus net credit received.
In reality, an iron butterfly is nothing more than a bull put spread and a bear call spread tied into one. However, you want to place this trade with your broker as one trade. When looking at a possible iron butterfly, figure the total credit you want to receive and let your broker know you only want to enter the trade if this credit or better is achieved. We don’t care at what price the broker gets each option, just that our net credit figure is received.
During the next week, do some searches for possible iron butterfly candidates and then enter a paper trade on a couple. I’ll do the same and in next week’s article, we’ll choose a security to track using this neutral trading strategy. If you have any questions, please post them on my forum. This way we can all learn together.
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