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Last week, we started a new series talking about the details and benefits of using an iron butterfly [see Part 1, 1/15/02]. Traders will often hear an iron butterfly also called an iron condor, so don’t be concerned if you see this term used on various websites or books. I stated last week that we would pick a stock to enter a mock trade on this week using this neutral trading strategy. Before we go into the details of this mock trade, let’s briefly review what an iron butterfly is.

An iron butterfly is a trading strategy that profits from the lack of movement in a stock. Basically, we are entering a bear call spread and bull put spread simultaneously. This means we are taking in two credits and we are able to keep them both if the stock stays in between the sold options strike prices. For example, if we find a stock that we feel will stay between 30 and 35, we might enter an iron butterfly using a bear call spread with the 35 and 40 strikes and a bull put spread using the 25 and 30 strikes. If the stock closes at expiration between 30 and 35, we would keep the whole credit. However, we always should know what the worst case scenario is as well. In an iron butterfly, if the stock closes outside the outer strikes, we would lose the maximum amount possible. In our above example, this would be figured by taking the difference in strikes, which is five points, and subtracting out the credit received. Thus, if we received two points, we are at risk by three points.

Since we are entering a trade that benefits from little movement and time erosion, we want to use options that expire in less than 45 days in most cases. Though we might be able to get a slightly higher reward-to-risk ratio by using longer-term options, we are also not going to see time erode the sold options as quickly and we are giving the stock more time to move out of its range. Some traders might be wondering when we should use a regular condor and when we should use an iron butterfly. This is very simple to answer because it all depends on the numbers. The risk profile for a condor is exactly the same as the risk profile for an iron butterfly. Thus, run the numbers and see which strategy offers the best reward-to-risk ratio. Now that we have reviewed what an iron butterfly is, let’s enter a mock trade to see how this strategy works in real life.

Before I tell you what stock I have chosen to track, let me tell you how I found it. Looking at different charts, I came across a chart of Amgen (AMGN). I immediately noticed that the stock hit resistance and looked to be rolling over. I also noticed that the stock had been trading in a range from about 40 to 53 for the last six and a half months. Though the stock closed at $50.87 on Tuesday, it seems likely that it will continue lower, leaving it between 45 and 50 by expiration in February. After seeing the range the stock was in, I checked the news to see if there was anything likely to move the stock sharply in either direction. Finding nothing, I looked at the implied volatility history of the stock. As of Tuesday, IV is in the lower half of the last six months of readings. Low IV is not necessarily a good thing, but it did tell me that there wasn’t any news that was expected to be released in the near term. So, seeing that there was a green light to enter a trade on Amgen, I then looked at the numbers. I looked at a condor using puts and calls and compared these with using an iron butterfly. After running the numbers, I noticed that an iron butterfly provided a slightly better reward-to-risk. Below is the data we are going to use for this trade.

Jan. 21, 2003
AMGN Iron Butterfly
Stock Price: $50.87
Buy 5 Feb 40 Puts @ 0.2 = -$100
Sell 5 Feb 45 Puts @ 0.55 = $275
Sell 5 Feb 50 Calls @ 2.60 = $1300
Buy 5 Feb 55 Calls @ 0.55 = -$275
Total Credit = $1200
Max Risk = $1300
Downside Breakeven = 42.60
Upside Breakeven = 52.40

As always, I have figured these prices working inside the spread when possible. It is always advisable to work the spread, as there is no reason to pay full sticker price for an option. There is plenty of open interest, so this should not be a problem. Now that we have a trade figured, let’s take a look at the risk graph:

Overall, this looks like a good trade, with AMGN having traded within our profit zone for the past three months-plus. Nonetheless, there are always things to learn and we’ll track this trade through February option expiration to see how it performs and to see if we need to make any sort of adjustments. If you have any questions or comments about this trade or an iron butterfly, please feel free to visit my forum on Optionetics.com.


Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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