Your portfolio can easily crash and burn when trading options, but this strategy could make your investments soar.
Updated Apr 20, 2023
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While we might think of the stock market and trading as a rather modern concept, some investing concepts, such as options, have been around since Ancient Greece.
The first known reference to options trading is from Aristotle. He recounts how Greek philosopher Thales forecasted that the next olive harvest would be good, and he placed a deposit on local olive presses. When the harvest proved bountiful, he rented out the olive presses for a higher price than he had secured them.
Modern options trading is a financial instrument investors use to build their portfolios. Options traders have their own lingo and strategies. One of those is the iron butterfly and iron condor strategy. Like covered calls, both strategies enable investors to limit their investment risk. In this article, we’ll cover the key differences and similarities between these two strategies. But before we begin, here’s a primer on how options work.
Before you start using the iron condor or iron butterfly strategies, you must understand how options work. Here’s a refresher.
An option is a derivative of stocks. In other words, its value is determined by an underlying asset. When an investor takes out an options contract, it gives the buyer the option—but not the obligation—to buy or sell the underlying asset. Unlike futures, options don't require the holder to buy or sell, hence the name.
Traders can use options to bet on the price of something going up or down in the future, just like Thales's bet on Greek olive oil. To do that, options traders use call or put options that can be either long or short.
Now that we covered what options are, let’s get into the nitty-gritty of the iron condor vs the iron butterfly options trading strategies.
The iron butterfly and iron condor are two similar options trading strategies that make the maximum profit when the underlying asset has a decline in implied volatility. Options traders generally use either the iron butterfly or iron condor when they think option prices are likely to remain stable. In other words, it’s a bet on low volatility in the market.
Both iron condors and iron butterflies are strategies that use different options contracts in the hopes of gaining a profit, namely short and long calls and a long and short puts. The biggest difference is how the strike prices and premiums of the short contracts are positioned.
An iron butterfly, or iron fly, uses two put options and two call options that are distributed among different strike prices but all have the same expiration date. A short call and short put are sold in the money (in other words, the strike price is the same as the price of the underlying stock). Meanwhile, a long call and long put are purchased out of the money (meaning the stock hasn’t reached the strike price yet).
For example, let’s say KO is trading at $50 a share. With an iron butterfly strategy, the trader would buy a short call and put option at the $50 strike price, receiving a $5 premium for each contract, then buy another long call and put for $1 each. Assuming the trader put in a call for 100 shares, the options trader would get an $800 credit.
For the iron butterfly strategy to work, the underlying asset has to get as close to the middle strike price as possible. Using the same example of KO, the middle strike price would be $50, while the upper break-even point would be $58 ($50 + $8.00 (x 100 shares = $800)), and the lower break-even point would be $42 ($50 - $8.00 (x 100 shares = $800)). If the price rises above or below those points, then the trader will have a net loss.
Example of how an iron butterfly strategy works.
Like the iron butterfly, iron condors use long and short puts and long and short calls along with four strike prices. However unlike the iron butterfly, the short position strike prices are different. Usually, they are sold out of money, with the short call sold above the stock's price and the short put sold below the current price.
There are also other variations of the iron condor. Namely, the bearish iron condor and bullish iron condor. A bearish iron condor is when the strike prices are at a point lower than the underlying asset’s current price, while a bullish iron condor is when the price point is higher.
As an example, let’s say that a stock is trading at $50 a share. An iron condor would have different strike prices for all of its calls and puts. An example position might be:
Because your short positions are different, you have a bigger margin of error then with an iron butterfly strategy, allowing the asset price to rise or fall before the strike price is met. In this example, the short call is $55 while the short put is $45. If the trader has a $1.15 net credit, then the break-even prices would be $53.85 and $46.15.
Example of how an iron condor options trading strategy works.
While at first glance the iron condor and iron butterfly options might seem very similar, the biggest difference is that iron condor uses different short strike prices while the iron butterfly uses the same short strike price for both short options.
The reason for this is that an iron butterfly has a higher profit potential but has a bit more risk than an iron condor. Still, both strategies generally only work when the price of the underlying options contract is within a specific trading range. In other words, it only works when implied volatility is low, and the price of the asset is stable.
If you want to use iron butterflies or iron condors, you’ll need to trade options, which you can do at any brokerage that supports options trading. Because options trading is a more sophisticated investing strategy than simply investing in ETFs or stocks, not all online platforms offer options trading to retail investors.
A few platforms that do offer it include TradeStation and Robinhood. With Tradestation, you can get access to advanced tools and trading information that let you invest in stocks, futures, options, and even crypto. But for those new to investing in options, Robinhood is a bit easier to navigate and use.
Whether an iron condor or iron butterfly is a better options trading strategy really depends on your own personal trading style. Both strategies work best when the underlying asset has low volatility. While an iron condor has more movement range, you also have a lower earning potential. The iron butterfly strategy gives you more earning potential but has more risk.
In short, both strategies allow you to take advantage of price movements in a specific range but vary on how they execute that strategy. However, keep in mind that these investing strategies are complex and require extensive research and understanding of the markets.
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