Spread Trade #3 - Iron Butterflies (and #4 - Iron Condors)

Over the past two weeks, we’ve looked at Butterfly and Condor spreads. You’ll recall that both spreads are a way to profit if the price of the underlying security moves (in either direction) or, conversely, doesn’t move at all.

Although we did take a brief look at spreads that would profit if the underlying stock moved to a very specific price, we spent most of the time discussing spreads that were fairly close to at-the-money (the current stock price) when we initiated the trade.

There’s one problem with these spreads – that they contain one leg that’s in-the-money. In general, options that are in the money trade at a wider bid/ask spread.

Remember also that a call is a put and a put is a call in terms of the potential payoff from an options trade, so we can replicate the p/l profile of a butterfly or condor buy combining calls and puts in the same spread while trading only the more liquid at-the-money and out-of-the-money options.

Example:

Disney (DIS) stock is trading around $140/share.

Current options prices for the August expiration with 22 days to expiration are:

If we were buying the 130/140/150 butterfly, we’d pay a debit of $4.58 per spread. If the price of the stock is exactly $140/share at expiration, the spread will be worth $10.00, leaving us with a maximum profit of $5.42.

The p/l diagram looks like this:

We might be able to do a bit better, though.

If instead of buying the butterfly, we sell the Iron Butterfly, we can pay less in bid/ask spread and get functionally the same p/l profile.

Here’s how it works:

We buy the 130 put, sell one each of the 140 put and the 140 call and buy one of the 150 calls. I used the term “sell” because this trade is going to result in a net credit to us. If Disney shares are exactly at $140 at expiration, our spread will be worth zero and we’ll keep the entire premium collected.

At current market prices, we would collect $5.62 per spread. This is our maximum potential profit. And our maximum risk would be the spread being worth $10 at expiration, representing a loss of $4.38.

The p/l diagram looks like this:

Notice that it’s almost identical to the butterfly, but the potential profits and losses are shifted $20 higher. We’re risking a little less and stand to make a little more.

(If you’re new to spread trading, I definitely recommend drawing expiration p/l diagrams on paper. Figure out what each option will be worth at various stock prices at expiration and plot the total value of the spread yourself. It’s a great exercise to get used to how the individual options contribute to the final value of the spread.)

The difference is in the bid/ask spreads. The 130 call is 25 cents wide while the 130 put is only 3 cents wide. If we can create the same basic spread but with a more favorable risk/reward ratio, we definitely would.

Now $20 per spread difference may not seem like a lot relative to a spread where we might make or lose something around $500, but those small amounts definitely add up over months or years of trading.

Savvy professional traders never intentionally leave any money on the table and neither should you.

These same principles apply to a condor to make it an iron condor instead. For instance, buy the 135 puts, sell the 140 puts, sell the 145 call and buy the 150 calls. We’re still trading out-of-the money options and taking advantage of the tighter bid/ask spreads.

So just remember our adage that “a call is a put and a put is a call” and you’ll be able to construct your spreads in the most efficient possible way and maximize your chances for positive returns.

-Dave

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