Comparing sideways market strategies

February 15, 2015 12:00 PM
For those times when trends are in short supply, what is the superior strategy for banking option premium: The iron butterfly or the iron condor?

Iron condor

Now let’s look at the iron condor. The profit/loss graph for the IC is shown in “Iron condor profile” (right).

You are long an OTM put (strike A), short a lesser OTM put (strike B), short OTM call strike C, and long a farther OTM call (strike D). As you can see, you are basically short two OTM vertical spreads: call spread C/D and put spread A/B.

As in the iron butterfly, you want all four options to expire worthless, meaning an expiration anywhere between B and C. The credit you receive upon placing this position is also the maximum profit. The iron condor thereby has a larger sweet spot, or zone of maximum profit, than the iron butterfly.

Your risk is limited to strike B minus strike A minus the net credit received. Your two breakeven points are strike B minus the net credit received, and strike C plus the net credit received.

Once again, all strikes must be equidistant, and the stock or index should be exactly between B and C.

Because our purpose here is to understand the differences of the two strategies and to consider their pros and cons, let’s stay with SPY for comparative purposes. We have the same MMT, so now we are going to be short the 198 put at 1.50 and short the 210 call at 0.60. Against that, we buy the 194 put at 1.00 and the 214 call at 0.15 (more skew!) for a credit of 0.95. This is a lesser credit, to be sure, but the position has a much wider sweet spot.

Now, let’s contrast the iron butterfly vs. the iron condor using a stock option. We’ll use Google (see “GOOG golly,” below). For the sake of the example, let’s assume our analysis suggests that GOOG will be range bound through December.

With GOOG at 545.38, we use the 545 straddle to find our MMTs. The 545 straddle is trading at 25.00 (12.70 in the call and 12.30 in the put). We sell that straddle and buy the 520/570 strangle at 8.50. That’s 4.00 in the 570 call and 4.50 in the 520 put (much lesser skew!). This gives us the following scenarios:

  • An expiration at exactly $545 earns 16.50 for the position, or $1,650 per position. Any expiration below $520 or above $570 costs the position 8.50, or $850. Our breakeven points are $528.50 and $561.50.
  • For the iron condor, we sell the 570 call at 4.00 and sell the 520 put at 4.50. Against that we buy (using equidistant strikes) the 495 put at 1.50 and the 595 call at 1.00 for credit of 6.00. We make this $600 at any expiration between $570 and $520. Any expiration below $495 or above $595 costs the position 19.00 points, or $1,900.

Comparison

One word of warning regarding this strategy—the stock market adage, “never short a dull market” comes to mind. As counter-intuitive as it may seem, you want to put on a range-bound trade when the underlying value has been volatile, not dormant. Just like you buy dips and sell rallies, you should be long premium in periods of low volatility when nothing is happening and short premium in periods of high volatility when a lot is going on. If you sell premium in a dull market, you won’t collect enough credit to make the risk worthwhile.

Let’s break it down. What do we prefer: 

  • The IB has a better risk reward ratio
  • The IB requires closer monitoring
  • The IB is usually more liquid, therefore easier to adjust
  • The IC has a larger sweet spot 
  • The IC has a smaller payout

While both strategies have benefits in certain market conditions, when all these variable are taken into consideration, the iron butterfly is the superior position for a sideways market.

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About the Author

Randall Liss is a veteran options trader. He helped found the European Options Exchange in Amsterdam (now part of Euronext), was a market-maker for that exchange and is co-founder of The Market-Makers Association. Liss has educated and mentored traders since 2006.