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Investor mulls his options

Iron condors and iron butterflies are very similar and popular options trading strategies. Both can profit by selling short positions in the face of low implied volatility, and both use long positions to limit risk. Though similar, there are key differences. The major one is that the maximum profit zone for a condor is much bigger than that for a butterfly, but the tradeoff is a lower profit potential. Here’s what you need to know. 

In addition to options, a financial advisor can show you other ways to book gains in a quiet market.

What Are Iron Condors and Iron Butterflies?

Iron condors and iron butterflies are options trading strategies. These positions are a bet on stability. The less an asset’s price moves, the more money you make. The more volatile the asset, the higher your risk of loss.

Both strategies are built with four simultaneous options contracts, two long and two short.

  • Put/Call – A put option is one in which the holder has the right to sell the underlying asset for a certain price on a specific date. A call option is one in which the holder has the right to buy the underlying asset for a certain price on a specific date.
  • Long/Short – A long position in an options contract means that you bought the contract and hold the rights that this contract gives. A long call means you, as the buyer of the contract, can buy the asset for a given price, giving the contract value if the asset’s market price increases. A long put means that you can sell the asset for a given price, giving the contract value if the asset’s market price falls. A short position means that you sold the contract and must honor those respective rights. So, a short call means that the call seller must sell the asset to whoever holds the contract should the holder of the contract exercise their option. Alternatively, a short put means that you must buy it from whoever holds the contract.

For both an iron condor and an iron butterfly you open options contracts with identical expiration dates:

  • Long Call: Buy a call contract with a strike price above the current price of the asset.
  • Long Put: Buy a put contract with a strike price below the current price of the asset.
  • Short Call: Sell a call contract with a strike price below your long call.
  • Short Put: Sell a put contract with a strike price above your long put.

Once this is finished you will have a position built out of four points. Your short positions will have their strike prices clustered in the middle, typically built around the asset’s current strike price. Your long positions will have strike prices above and below the shorts.

With both an iron condor and an iron butterfly your strategy is based on the balance between your short and long positions.

Both strategies profit off the premiums you make by selling your short positions. Because the strike price on the short contracts is closer to the asset’s current price than the strike price on the long contracts, you collect more by selling the short contracts than you spend buying the long positions. As a result you open your strategy in a position of profit.

Iron condors and iron butterflies cap their risk through their long positions.

If an asset’s price moves from its starting position it becomes increasingly likely that you will have to pay one of your short positions. This increases your risk of loss.

However, once the asset’s price moves too far from its starting position, one of your long positions also goes into the money. At that point you collect $1 from your long position for every $1 you pay on the short position. This caps your maximum losses. You cannot lose more on an iron condor or an iron butterfly than the difference between your long call/put and short call/put.

How Do They Compare/Contrast?

The difference between an iron condor and an iron butterfly comes in how you structure the strike prices and the premiums of your short contracts.

In an iron condor your short contracts have different strike prices and lower premiums. In an iron butterfly they have the same strike price and higher premiums.

  • Iron Condors

In an iron condor there is a gap between the strike price of your short put and the strike price of your short call. Typically this is centered on the asset’s current price. For example, you might build a position where the short call strike price is set 10 points higher than the asset’s current price and the short put strike price is set 10 points lower.

When you build your strike prices around a central point lower than the asset’s current price, this is called a “bearish iron condor.” It means you expect the asset’s price to fall then stabilize. When you build your strike prices around a central point higher than the asset’s current price, this is called a “bullish iron condor.” It means you expect the asset’s price to rise before steadying.

  • Iron Butterflies

In an iron butterfly the strike prices of both short contracts are the same. Typically you set both strike prices to the current price of the asset.

When you set your short positions to a strike price lower than the current price, this is called a “bearish iron butterfly.” When you set your short positions to a strike price higher than the current price, this is called a “bullish iron butterfly.” As with an iron condor, this indicates that you expect prices to change and then stabilize.

  • Iron Butterflies charge higher premiums

In an iron butterfly your short position strike prices are closer to the asset’s current price than in an iron condor. As a result, you collect higher premiums for selling these short positions than you do from selling an iron condor’s short contracts.

In an iron condor your short positions have some distance from the asset’s current (or anticipated) strike price. As a result, you have room for more volatility before you begin taking losses than an iron butterfly allows.

Example of an Iron Condor vs. an Iron Butterfly

Say that XYZ Corp. is currently trading for $20 per share. An iron condor with one contract per position (100 shares) might look like this:

  • Long Call, Strike price $30, Expiration January 1, Premium $1/Share
  • Long Put, Strike price $10, Expiration January 1, Premium $1/Share
  • Short Call, Strike price $25, Expiration January 1, Premium $2/Share
  • Short Put, Strike price $15, Expiration January 1, Premium $2/Share

Since your short contracts are closer to being in the money than your long contracts, they have higher premiums. With the iron condor each short position gives you a margin of error. The asset price can move up or down before either short contract goes in the money. This margin of error is the difference between an iron condor and an iron butterfly.

An iron butterfly with one contract per position might look like this:

  • Long Call, Strike price $30, Expiration January 1, Premium $1/Share
  • Long Put, Strike price $10, Expiration January 1, Premium $1/Share
  • Short Call, Strike price $20, Expiration January 1, Premium $3/Share
  • Short Put, Strike price $20, Expiration January 1, Premium $3/Share

This is a standard iron butterfly position, which means you have sold your short contracts “at the money.” It is almost certain that one of these contracts will go in the money since the probability of $0.00 movement is extremely low. This allows you to charge a high premium for each contract.

However, an iron butterfly starts with no margin of error. The question is not how much XYZ Corp. can move before you begin paying on this position. Instead, it is whether this stock will move so much that your losses on the short position exceed the premiums you collected up front.

In both strategies your risk is capped by your long positions. If the asset’s price moves by enough to cause either your long call or your long put to go in the money your profits from that contract offset any further losses from your short position.

When to Use an Iron Butterfly vs. an Iron Condor

Investor types on his PC

An iron condor is a lower risk, lower reward position. An iron butterfly is a higher risk, higher reward position. Since an iron butterfly’s short positions are set close to or at the asset’s current price it collects higher premiums than an iron condor can. You can always make more money with an iron butterfly if everything goes well. This is the strategy to employ if you expect rock bottom volatility.

An iron condor offsets this lower profit potential by building in a safety net. You set your short positions some distance out from the asset’s current price. This means they’re worth less, so you get less money by selling them, but it also means that the asset’s price can change without your position losing money.

To understand that fully, let’s look at our two examples from above again, where XYZ Corp. is currently trading for $20 per share.

Iron condor, one contract per position:

  • Long Call, Strike price $30, Expiration January 1, Premium $1/Share
  • Long Put, Strike price $10, Expiration January 1, Premium $1/Share
  • Short Call, Strike price $25, Expiration January 1, Premium $2/Share
  • Short Put, Strike price $15, Expiration January 1, Premium $2/Share

Iron butterfly, one contract per position:

  • Long Call, Strike price $30, Expiration January 1, Premium $1/Share
  • Long Put, Strike price $10, Expiration January 1, Premium $1/Share
  • Short Call, Strike price $20, Expiration January 1, Premium $3/Share
  • Short Put, Strike price $20, Expiration January 1, Premium $3/Share

At the outset, the iron butterfly is a far more profitable position. Our iron condor opens with the following revenue:

  • $2 (the short premiums) x 200 (the number of shares in two contracts) = $400
  • $1 (the long premiums) x 200 (the number of shares in two contracts) = $200
  • $400 – $200 = $200 Starting Gains

Our iron butterfly opens with:

  • $3 (the short premiums) x 200 (the number of shares in two contracts) = $600
  • $1 (the long premiums) x 200 (the number of shares in two contracts) = $200
  • $600 – $200 = $400 Starting Gains

At the outset our iron butterfly position is worth $400, much more than the iron condor was. This will remain true so long as XYZ Corp.’s price does not change. This is the high reward aspect of the iron butterfly.

The downside to an iron butterfly begins if the asset shows volatility. With the iron condor, XYZ Corp.’s price can change by $5 on either side and the position will retain its full value because neither short position will go in the money.

If XYZ Corp. fluctuates by more than $5, the iron condor will begin to erode. For example if XYZ Corp.’s price rises to $25.50, our profits will drop to $150. (The long position will go in the money for $0.50 per share at 100 shares, for a $50 loss against our starting $200 gain.)

Once XYZ Corp. hits either $13 or $27 our iron condor will lose all its value. At $13, for example, the short put we sold will lose $2 per share. At 100 shares the short put costs us $200 agains our initial $200 gain.

We will actively lose money if XYZ Corp.’s price climbs above $27 or drops below $13, since at that point we will pay more on the short position than we collected in premiums. At $30 or $10 one of our long positions will go in the money, earning us $1 for each additional $1 we lose on the short position and capping our total losses.

Put in technical terms, this means that our iron condor has:

  • Maximum profit: $200
  • Maximum loss: $300 (A $500 payment on one short contract, reduced by our initial gains)
  • 0 – 5 points of volatility: No loss
  • 5 – 7 points of volatility: Eroding value
  • 7 points of volatility: Breakeven point
  • 7 – 10 points of volatility: Losing money
  • 10+ points of volatility: Capped losses

With the iron butterfly our position begins to erode almost immediately. If XYZ Corp.’s share price changes at all, one of the short contracts that we sold will go in the money. The question is whether the short position’s losses will exceed the higher profits made by selling our more expensive premiums.

In our example above, if XYZ Corp.’s share price drops to $19 we will lose $100 on the short put that we sold. (It will go into the money for $1 per share at 100 shares.) This will reduce our total profits to $300. (Our position started at $400, now less the $100 we have to pay on this short contract.) By contrast, at $19 the iron condor hasn’t lost any value yet.

If XYZ Corp.’s share price drops to $16 we will lose $400 on the short put that we sold. (It will go into the money for $4 per share at 100 shares.) By $15 per share our short put has exceeded the value of our starting position. We will pay $500 on this contract compared to the $400 we started with, for a net loss of $100.

Put in technical terms this means that our iron butterfly has:

  • Maximum Profit: $400
  • Maximum Loss: $600 (A $1,000 payment on one short contract, reduced by our initial gains)
  • 0 – 4 points of volatility: Eroding value
  • 4 points of volatility: Breakeven point
  • 4 – 10 points of volatility: Losing money
  • 10+ points of volatility: Capped losses

An iron butterfly collects more money up front and has a higher potential for overall profit than an iron condor does. However, it comes with greater risk. You can lose more money, and will generally lose money earlier in cases of market volatility.

An iron condor has less chance for overall profit than an iron butterfly does. It offsets this with a risk mitigation strategy that allows for more market volatility before you begin taking losses, and lower losses overall, than with an iron butterfly.

The Bottom Line

Short and long positions in a balance

Iron condors and iron butterflies are options trading strategies that bet on low volatility. An iron butterfly has the potential for higher profits but at higher risks. An iron condor gives you some room for error but with less profit potential. Because these are options strategies it is essential that investors fully understand how options work – for example, how options differ from futures – and the possible downsides of using these relatively sophisticated strategies.

Tips for Investing

  • One way to decide if it’s time to look for ways of booking profit in a flat market that looks range-bound is by using an investment calculator.
  • Risk vs. reward is key to investment. Every choice you make balances these priorities, and one of the best ways to strike that balance is with the help of a trained financial advisor. Finding one doesn’t have to be hard. SmartAsset’s matching tool can help you find a financial advisor in your area to help you figure out how your investing and what you’re doing it all for. If you’re ready, get started now.

Photo credit: ©iStock.com/phototechno, ©iStock.com/Blue Planet Studio, ©iStock.com/chaofann

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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