They sell options to traders looking for big wins, and when those options expire to nothing, the option seller can keep the premium he has collected.
Many traders use these spreads to trade range-bound markets with sustained technical ranges with well-defined support and resistance levels. These are winning trades when the market stays within a defined range throughout the duration of the trade.
Both the Iron Condor and the Iron Butterfly utilize the same market dynamics, but there are situations where it makes sense to use one over the other.
Sell Option: Short Sell Volatility
Both the Iron Condor and the Iron Butterfly are directionless, limited risk option spreads. Instead of being bullish or bearish and trying to make a profit, these option spreads are a tool to profit from options that have expired and seem worthless.
If you’ve had a chance to look at the options market during the GameStop madness of 2021, you’ve seen insane options prices. A great many traders wanted to bet against stocks but didn’t want to be destroyed by a short squeeze, so they preferred to buy puts. You could lose money even if you did it right.
When you short an option, you are selling it to another buyer. For example, a stock at $15 has a strike price and he calls at $20 and he sells at $1. The stock is still $15 at expiration and the option expires with no value. You can hold the entire $1.
It is well known that most options expire, so this is an attractive trade for many traders. The downside, however, is unlimited risk when shorting options. Suppose the inventory in the example above was $30 at maturity. The option is worth $15 and you are in the $14 hole.
For this reason, many traders use spreads such as Iron Condors and Iron Butterfly to limit the downside. These spreads include short options, but also buy OTM options to limit risk.
What is Iron Condor?
If you are familiar with other option spreads, the Iron Condor combines a short vertical call spread with a short vertical put spread. In other words, it’s a short stranglehold to buy “wings” (OTM option) to cover the downsides.
If you’re unfamiliar with the jargon-filled dictionary used by options traders, Iron Condor involves shorting out-of-the-money (OTM) puts and calls and buying OTM puts and calls. will be
These additional OTM options we purchase are used to limit the downside. Since short options come with unlimited downsides, iron condors have the advantage of shorting options and the added advantage of limiting downsides.
Here’s a visual representation of the Iron Condor.
What is Iron Butterfly?
Iron Butterfly is like an Iron Condo, with a higher reward/risk ratio but lower profit probability.
The main difference is the short strike. The Iron Condor looks like this when the underlying asset trades at $32:
● Buy (5) 28 Strike Call
● Sell (5) 30 Strike Call
● Sell (5) 32 Strike Put
● Buy (5) 34 Strike Put
The equivalent Iron Butterfly looks like this:
● Buy (5) 30 Strike Calls
● Sell (10) 32 Strike Call
● Buy (5) 34 Strike Call
When choosing a strike in an Iron Condor or Iron Butterfly trade, you are defining a range within which the underlying asset is expected to remain.
With a much wider range, the Iron Condor is more forgiving. The Iron Butterfly, on the other hand, short puts and calls with the same strike, resulting in a narrower defined range and less chance of making a profit on the trade. However, you can make more money if your deal is right.
Compare the Iron Butterfly and Iron Condor payoff diagrams.
First, here is the payoff diagram for the Iron Butterfly.
In short, Iron Butterfly is the trade of choice if you believe the stock will settle within a narrow range before expiry. Your potential rewards are much higher for doing things right. On the other hand, if you want a little more leeway in the market, the Iron Condor is your favourite.
Conclusion
Note that option spreads are a trade construction, not a trading strategy. There is no inherent advantage in trading iron condors or iron butterflies. They are just tools to apply to market dynamics where the market is likely to remain rangebound.
To summarize:
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The Iron Condor consists of both short vertical spreads and short vertical put spreads.
- Iron Butterflies consist of one short option and two long “wings” to protect your weak points.
