In this article, we will discuss
- What is an Iron Condor?
- How to Construct an Iron Condor?
- Features of an Iron Condor Strategy
- Meaning of Butterfly Spread
- How Does a Butterfly Spread Work?
- Different Types of Butterfly Spread
- Conclusion
- FAQs
If you are trading in options, you can’t simply just pick an asset and invest in it. As a day trader, you must implement different option trading strategies to analyse the market, pick right stocks and protect your capital. In order to create an additional layer of safety, seasoned investors often use hedging techniques. Such techniques help them minimise their losses.
If you are familiar with the basics of hedging, you can start your trial and run with more advanced trading strategies. Two such strategies are iron condor and butterfly spread. In this blog, we will cover basics of these two strategies so you can determine whether they are a good fit for you.
What is an Iron Condor?
Every option trader opens a position based on one of these two predictions – either the price of the security will go up or it will go down. However, what if you are a trader who wants to leverage the market when the price doesn’t fluctuate by a very high degree? If you answered the question with a yes, then an iron condor strategy can work like a charm for you.
One thing to take note of here is that all these four options shall be of different strike prices but carry the same expiration date. This strategy works best when your underlying asset has a low price volatility. For this to happen, asset prices must close between the middle strike prices.
How to Construct an Iron Condor?
If you feel this strategy sounds something similar to a strangle, then you are absolutely correct. An iron condor is an improvisation of the strangle, and you can create it in two ways, i.e. long and short.
Short iron condor
This is one of the more commonly used condors, and it starts with your trade generating a net credit. Here are the steps to its construction:
Step 1: Start with buying one out-of-the-money (OTM) put option. Make sure the strike price of the put is below the current price of its underlying asset. This will help in limiting your risk in case of significant downside price movement.
Step 2: The next step is to sell an OTM put option. This put option must have its strike price closer to the current strike price of your underlying asset.
Step 3: Now, it is time to shift to the calls. Sell one OTM call option. This call option must have its strike price above the current market price of your underlying stock.
Step 4: The last step is to buy an OTM call option. The strike price of this call option must be even higher than the strike price of your previous call. This will help you protect your trade in case of a massive market rally or uptrend.
Long iron condor
This is not as common as the short condor and is mostly used in very advanced trading. It is used in cases where a trader wishes to take advantage of a massive price movement in the market. Its formation is just the opposite of a short condor.
Step 1: Buy an OTM put option with a strike price lower than the current market price of the underlying asset.
Step 2: Sell a deep OTM put with a strike price that is further below the price of the previous put.
Step 3: Buy an OTM call option with a strike price above the current market price of the underlying asset.
Step 4: Sell a deep OTM call option. The price of this option must be even higher than the price of your last call.
Features of an Iron Condor Strategy
Here are some key features of this trading strategy:
- A trader can use this strategy to make profits in a sideways market.
- It resembles the condor bird with two wings. If you look at the graph, the options with the outer strike are called the wings of the condor.
- The wings of the condor help limit the risks in case there is a massive price rally or decline in the current market price of the underlying security.
- Since the formation of an iron condor limits your losses, it also sets a cap on the maximum profit you can earn.
- In the case of a short condor, the net inflow is a profit, whereas in the case of a long condor, the net inflow is usually a loss.
- Traders use a short condor when they predict less volatility in the stock price of an asset.
- A long condor is a better choice if you think the price shall be more volatile and the trend won’t exactly be sideways.
- For a trader to make a profit in this strategy, it is important that all four options become worthless at the time of exiting the trade.
Meaning of Butterfly Spread
The butterfly spread is another neutral option strategy that works better in case of a sideways market trend. It is also an extension of the above-discussed condor strategy.
It is also a four-legged strategy with a combination of bear and bull spreads. However, unlike the former, this uses only three strike points with four options.
Another difference here is that the iron condor is made up of one call spread and one put spread. However, the butterfly is made up of either two call spreads or two put spreads.
Finally, in the case of a successful butterfly spread, one spread becomes worthless at the end, but the other spread has to go out worth its full value.
How Does a Butterfly Spread Work?
The risk in using a butterfly spread is fixed and the profits and losses are also capped. A trader can use either four calls, four puts or any combination of calls and puts to create this spread. The only condition is that two options must have the same strike price.
- Now you will have to buy two options contracts where one shall be of a higher price and the other of a lower price.
- The third option shall be an at-the-money (ATM) strike price or the middle strike price.
- You sell two ATM options with the same strike price.
The trick here, however, is that the higher and lower strike prices shall be equidistant from the ATM strike price. Hence, if your ATM strike price is, let’s say, ₹70, then your higher and lower strike prices can be 80 and 60, or 90 and 50. As you can see, the first set has a ₹10 price difference from the ATM price and the second set has a difference of ₹20.
When you combine your options in different ways, you create different types of butterfly spreads.
For the spread to work best, it is better to have a non-directional market or a market where the price of the underlying asset remains stagnant. It shows the best results when it is close to its expiry, and the price of the underlying asset is the same as the middle strike price.
Different Types of Butterfly Spread
While trying to make different combinations of calls and puts to create a butterfly spread, a total number of 6 such spreads can be created. Let’s take a look at them.
1. Long Call Butterfly Spread
It is one of the best butterfly spreads.
You need to buy one call option with a low strike price and one call with a higher strike price. You sell two call options at a middle price. You get a net debit when you enter a long call butterfly spread.
In this strategy, the total cost you pay for the premium and commissions is the maximum loss you can incur. The current price of the underlying asset should match the medium strike price for maximum profits.
2. Short Call Butterfly Spread
You sell one call option with a lower strike price and another call with a higher strike price. The other two call options are to be bought at middle strike price.
Maximum profit you can make is the initial premium minus the commission. You get a net credit when creating the spread.
3. Long Put Butterfly Spread
Start by buying one lower strike price put and one higher strike price put. For the middle strike price, sell two puts. It creates a situation of net debt.
Maximum profit is the difference between the higher strike price minus the sum of the strike price of the sold put and the premium paid.
4. Short Put Butterfly Spread
Write one put with a lower strike price and one put with a higher strike price. Now, you need to buy two puts with a middle strike price.
This creates a situation of net debt, and the maximum profit can be the premium received. You can attain this if the current price of the underlying asset is above the higher strike price or below the lower strike price.
5. Iron Butterfly Spread
It is a combination of two calls and two put trades.
You buy one put with a lower strike price and sell one put at a middle strike price. The call you buy is at a higher strike price, and the call you sell is at the middle strike price.
It results in a net credit, and the maximum profit is attained when the current price of the underlying asset is the same as the middle price. Best suited for low volatility underlying assets.
6. Reverse Iron Butterfly Spread
Traders use it if they believe that the price of the underlying security is likely to make a sharp upward or downward move.
Sell a put with a lower strike price and buy the other at the middle strike price. For the calls, sell one at a higher price and buy the other at the middle strike price.
It is a net debt situation and works best for scenarios of high volatility. When the price of the underlying security moves above the higher price or below the lower price, that is when it gives you the maximum profits.
Conclusion
Both these options trading strategies are highly advanced and involve a certain level of complications. To be able to use these strategies, you must possess a decent level of market understanding and have a good knowledge of options trading.
Both these strategies, however, are suitable for traders who are not looking for exponential profits as they come with limited losses and limited profits. If you want to make higher profits, these options trading strategies might not work for you.
Finally, since both of them involve multiple buying and selling, it is crucial to have a robust options trading platform that can quickly execute all the orders. You can check out the New-gen Samco trading app for all your trading needs.
Frequently Asked Questions
Q1. What are net credit and net debit in options trading?
Ans. A situation of net credit or debt arises when you buy more than one option. A net credit is the net gain you make when buying and selling these options. However, when you incur a loss, it is net debt.
Q2. What is the meaning of a neutral options strategy?
Ans. It is an options strategy to leverage the price condition of an underlying asset that is going to remain static. It does not move upward or downwards.
Q3. What are in-the-money (ITM) and out-of-the-money (OTM) call options?
Ans. An in-the-money (ITM ) option is when the strike price of a call option is higher than its spot price. An OTM option is where the spot price is higher than the strike price of the call.
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