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Options trading presents a profitable yet risky endeavour for investors. Among the various strategies available, the iron condor and iron butterfly are popular choices for those seeking to generate income while limiting potential losses.
In this article, we will look into the intricacies of these two strategies and their differences for you to decide which might be better suited for your investment goals.
What is an iron condor option strategy?
The iron condor is a non-directional options strategy that uses four options with a long and a short call option for each option type. The expiration dates of all options are identical.
The strategy focuses on profiting from the underlying asset’s lack of substantial price movement within a particular time frame. To construct an iron condor, one must first sell an out-of-the-money (OTM) put option, and then purchase another OTM put option at a less expensive strike price.
Then, one must sell an out-of-the-money call option and purchase another out-of-the-money call option at a more expensive strike price.
Consider a stock trading at ₹7,500. To implement a bull put spread, you could sell a put option with a ₹7,450 strike price and buy a put option with a ₹7,400 strike price. Concurrently, for a bear call spread, you would sell a call option (strike price ₹7,550) and buy a call option (strike price ₹7,600).
This strategy establishes a ₹150 wide iron condor centred around the current trading price of ₹7,500. The goal is to profit from the stock price staying within the range of ₹7,450 to ₹7,550 until the options expire.
How to adjust the iron condor?
When the underlying asset price fluctuates, iron condor adjustments may become necessary to manage risk and potential losses. When you adjust an iron condor, you usually end up with more credit, which means higher profit potential, less risk, and greater break-even points.
Common adjustments include rolling the position to a later expiration date and closing out one side of the trade (either the put spread or the call spread). It is also possible to change the strike prices so they reflect the present market situation.
What is the iron butterfly options strategy?
The iron butterfly options strategy is neutral in nature. This trading strategy consists of four options: two calls and two puts. With this approach, you may lower your risk by purchasing out-of-the-money call and put options and selling call and put spreads with identical expiration dates.
By purchasing an OTM put option with a less expensive strike price than the option’s market price, this strategy intends to profit from a drop in option pricing.
Keep in mind that the strike prices of both the options (put and call) that were sold are identical. Though it’s less likely to be profitable, this method offers a higher risk-reward ratio compared to the iron condor.
Profitable iron butterfly strategies take advantage of low volatility and small fluctuations in the underlying stock. Opening a position results in a credit. Here, the spread width minus the premium collected represents the maximum amount of risk.
When an investor believes that the stock price will remain range-bound until expiry and that implied volatility will go down, they may initiate an iron butterfly.
Let’s say a stock is tradeable at ₹8,000. At the ₹8,000 strike price, you might sell a call and a put option to implement this strategy. To complete the strategy, you buy a call option at the ₹8,100 strike price and a put option at the ₹7,900 strike price, creating a spread of ₹200.
How to adjust the iron butterfly?
When the price of the underlying asset changes, you may need to modify your iron butterfly position, just like you would with an iron condor. Sometimes, traders may change the expiry date of a position, close out a trade (bull put spread or bear call spread), or change the strike prices to be aligned with how the market is going.
Difference between iron condor and iron butterfly
| Feature | Iron condor | Iron butterfly |
| Construction | A combination of a bear call spread and a bull put spread. | This strategy combines an OTM long strangle and an ATM short straddle. |
| Profit range | Wider profit range. | Narrower profit range. |
| Risk/reward ratio | Lower risk, lower reward. | Higher risk, higher reward. |
| Premium collection | This strategy collects less premium. | This method collects a higher premium. |
Conclusion
The iron condor and the iron butterfly are complex options strategies that require a deep understanding of the underlying asset’s behaviour and market conditions. While the iron condor offers a wider profit range, the iron butterfly can yield higher profits if executed correctly.
Finally, make sure these techniques are in line with your investing goals and undergo a careful review before implementing them.
FAQs
The difference between a butterfly and an iron fly lies in their structure and risk profile. A butterfly spread involves using three strike prices, typically one at-the-money (ATM), one out-of-the-money (OTM), and one in-the-money (ITM), with the same expiration date. An iron fly, on the other hand, is essentially an iron condor with the same middle strike price for both the call and put options, resulting in a position that has a higher risk and potentially higher reward compared to a butterfly spread.
A butterfly spread uses either all calls or all puts with three different strike prices, while a condor spread uses four strike prices. The butterfly spread has a narrower maximum profit zone but potentially higher returns within that zone. A condor spread, specifically an iron condor, has a wider maximum profit zone with lower potential returns within that zone. In the Indian market, these strategies are used to capitalise on different volatility expectations and views on the underlying asset’s price movement.
The iron butterfly strategy can be a good approach for experienced traders, especially in a low-volatility market. It allows traders to profit if the underlying asset stays within a specific range until expiration. The strategy involves selling ATM options and buying OTM options, which caps the potential loss while providing a premium income. However, it requires precise market predictions and may not be suitable for all investors.
The iron butterfly strategy offers several advantages for traders in India. It provides a defined risk-reward profile, which allows traders to know their maximum potential profit and loss upfront. This strategy requires a relatively small capital outlay and can generate steady income, particularly in low-volatility environments. Additionally, it is less risky compared to directional spreads and can be adjusted based on market movements.
The opposite of an iron condor is a reverse iron condor. While an iron condor is a net credit strategy that profits from the underlying asset trading within a certain range, a reverse iron condor is a net debit strategy that profits from a significant move in either direction of the underlying asset. It involves buying a debit spread above and below the current stock price, which requires a sharp move in the underlying asset for profitability.