The post Iron Condor vs. Iron Butterfly: Which Is Better? by Marc Guberti appeared first on Benzinga. Visit Benzinga to get more great content like this.
Options trading isn’t only for investors with higher risk tolerances. Iron condors and iron butterflies are lower-risk strategies that limit your losses and give you many ways to realize a profit. Traders can use these strategies to profit from markets that go up, down or sideways. While traditional stock trading is limited to profiting from up or down markets, these options trading strategies can thrive in low-volatility environments. This iron condor versus iron butterfly analysis will explore the differences between these popular strategies.
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Understanding Options
Options are derivatives that act as time-sensitive leverage for underlying stocks. An option gives the contract holder the right but not the obligation to buy 100 shares (call) or sell 100 shares (put) at the set strike price. The strike price’s distance from the stock price, volatility and expiration date are three key elements that impact the value of options contracts.
What Is an Iron Condor
An iron condor is an options trading strategy that thrives in low-volatility markets. The trader doesn’t want much movement in the stock price throughout the iron condor’s duration. But a trader with a short iron condor will want a sharp price movement in either direction to realize the maximum profit.
How Does the Iron Condor Work
The iron condor consists of four options with different strike prices but the same expiration date. A long iron condor starts with a trader selling a put and call that are both near or at the money. The trader then buys a further out-of-the-money call and a further out-of-the-money put.
The long call and put act as wings that limit the losses of the shorted call or put in case the stock’s price moves sharply in one direction. Buying a long call and put closer to the strike prices of the shorted call and put, respectively, will minimize your losses. Here’s what an iron condor can look like for a stock priced at $33 per share.
- Buy 1 out-of-the-money put with a $30 strike price
- Sell 1 near-the-money put with a $32 strike price
- Sell 1 near-the-money call with a $34 strike price
- Buy 1 out-of-the-money call with a $37 strike price
Iron condors result in a net credit. You receive a premium for initiating the trade that you can use for any investment. Some traders treat option premiums like dividend income and use it as part of a larger strategy to generate cash flow from their portfolios.
Advantages of Iron Condor
Iron condors offer several advantages for people who trade options.
- Iron condors let you limit your downside in case the stock moves in an unfavorable direction.
- The trader receives a premium right away that they can use for other investments.
- The setup allows traders to profit from low volatility, something that few strategies effectively accomplish.
Limitations of Iron Condor
Iron condors can be useful to include in your options trading toolkit, but no trading strategy is perfect. These are the limitations you may come across if you trade iron condors:
- Higher options trading fees can limit your return on investment (ROI). If you initiate several iron condors at the same time, an options broker with a flat fee for each order can save you money.
- Although iron condors limit your downside, they also limit your upside.
- The iron condor depends on low volatility. A sharp price movement in either direction can result in the maximum loss.
What Is an Iron Butterfly
An iron butterfly is an options trading strategy that has limited downside and incorporates four options contracts: two calls and two puts. The trader starts by selling a call and a put that are at the money. These options have the same strike price. Then, the trader buys one call and one put that are both out of the money. Choosing strike prices closer to the sold options will further minimize gains and losses. A wider gap between the strike prices will increase the max gain and max loss.
How Does the Iron Butterfly Work
An iron butterfly consists of four options and three different strike prices. The middle two options (short call and short put) have the same strike price, while the long positions act as the wings. The long call and put have lower premiums than the sold call and put, resulting in a net credit. The premium minus trading fees represents the max gain. The max loss occurs if the stock’s price falls below the out-of-the-money put’s strike price or above the out-of-the-money call’s price.
If a stock trades at $147, you can initiate an iron butterfly with the following four contracts:
- Buy 1 put with a $140 strike price
- Sell 1 call with a $145 strike price
- Sell 1 put with a $145 strike price
- Buy 1 call with a $150 strike price
Advantages of Iron Butterfly
The iron butterfly presents several advantages for options traders looking for new ways to potentially profit from stock price movements:
- Iron butterflies thrive in low-volatility markets. Most investments need a sharp price movement in either direction, but iron butterflies give traders more versatility.
- You receive a premium right away that you can use for any investment or expense.
- This options trading strategy minimizes your downside.
Limitations of Iron Butterfly
Iron butterflies have a lot going for them, but each trading strategy has strengths and weaknesses. These are some limitations of the iron butterfly to keep in mind before getting started:
- Iron butterflies limit your potential gains.
- You will incur higher trading fees because you have to trade four options to open an iron butterfly. An options broker with a flat rate instead of a per-contract fee may help you save money.
- High volatility can ruin an iron butterfly setup and result in a max loss. Traders can open short iron butterflies to capitalize on high volatility.
Major Differences Between Iron Condor and Iron Butterfly
Iron butterflies and iron condors are similar options trading strategies with similar objectives. Both trading strategies result in a net credit and limit losses if the trade doesn’t go your way. You can adjust the strike prices of the wings to determine your max gain and max loss. It’s possible to initiate a slightly bullish or bearish iron condor or iron butterfly depending on the strike prices you use for the out-of-the-money options.
When to Use
An iron condor is better if you believe the market may become more volatile. Iron condors are less risky than iron butterflies but have lower premiums. An iron butterfly may be the better approach if you believe the market will remain volatile. Iron butterflies are riskier, but your max loss is still limited, and you end up with a higher premium. Iron condors have a higher probability of being profitable than iron butterflies, but iron butterflies are more rewarding if you get them right.
Strike Price
Iron condors and iron butterflies have the same methodology for the wings. The long out-of-money call and put are both the furthest out of the money. The difference in strike prices lies in the sold call and put. An iron condor has four different strike prices, which means different strike prices for the short call and short put. An iron butterfly uses the same strike prices for the sold call and sold put.
Premium
Iron butterflies and iron condors both result in net credits, but you will receive a higher premium with an iron butterfly. The short call and put for an iron butterfly are usually positioned at or near the money. For an iron condor, the options get sold slightly out of the money.
Ironing Out the Details of Two Key Trading Strategies
Iron condors and iron butterflies let traders profit from sideways markets. These strategies let you set max gains and max losses that align with your risk tolerance. An iron butterfly is the riskier strategy but comes with a higher premium. Iron condors and iron butterflies can be useful options trading strategies for your portfolio.
How do you convert iron condors to iron butterflies?
You have to ensure the sold call and sold put have the same strike price. You can swap one of the short positions for another one so your middle options have the same strike price.
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What happens if you lose an iron condor?
Your max loss is limited based on the strike prices of the long out-of-the-money options. A trader can adjust the strike prices to take on an acceptable level of risk based on their risk tolerance.
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What happens if an iron butterfly expires?
An iron butterfly’s options that are out of the money will expire worthless. For a max loss scenario, you will not end up buying or selling shares because the options will cancel each other out. But you may have to buy 100 shares if the stock price falls between the out-of-the-money put and the sold put. If the price falls between the short call and the long call, you will have to sell 100 shares at the short call’s strike price.
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The post Iron Condor vs. Iron Butterfly: Which Is Better? by Marc Guberti appeared first on Benzinga. Visit Benzinga to get more great content like this.