Iron Condor vs. Iron Butterfly: How to Make the Most from Your Options Trade
Key Questions Answered
When it comes to trading options contracts in finance, there is truly no shortage of complex and innovative strategies that have been thought up by ambitious brokers over the years. Two such strategies are Iron Condor and Iron Butterfly.
What Is the Most Important Terminology Needed to Understand Iron Condor and Iron Butterflies?
To discuss options trading and the strategies involved for Iron Condor and Iron Butterfly, one must first have a base to work with. Below is a summary of some core options trading terminology to better understand Iron Condor and Iron Butterfly.
- Options contract: An agreement in which the option holder is given the rights, but not forced, to buy (call option) or sell (put option) a collection of shares at a predetermined price (strike price) and within a limited timeframe. This means that all options contracts have an expiration date, and the shorter the timeframe specified for that date, the higher the risk of loss.
- Security: Any financial asset that can be traded (like a call/put option contract).
- Long positions: Maintaining a long position simply means a holder owns a collection of shares through an options contract and expects the value of that security to increase, resulting in a profit.
- Short positions: A short position is where a holder sells (or gives up ownership) of an options contract, expecting its value to decrease. They will then buy back that security for a lower price, resulting in a profit.
- Options premium (henceforth simply called “premium”): The price at which an options contract is sold from one holder to another; as options contracts can be bought and sold too. This is why they are defined as securities.
Graphic of basic options definitions (Source: financecracker.com)
What Is an Iron Condor and What Is an Iron Butterfly?
Once you get to grips with the underlying terminology, the idea behind both an Iron Condor and an Iron Butterfly is fairly simple and straightforward. Both are trading strategies for the options market, and by default simply different methods to make money from options contracts.
They are in fact, both quite similar in a number of ways. Both are options trading strategies and both are based upon asset stability, meaning that the less the price of that asset fluctuates, the more capital the options holder stands to gain. Conversely, in both strategies, risk of loss increases the more the prices shift, meaning that they are both essentially a bet on market stability. Both the Iron Butterfly and Iron Condor strategies involve utilizing four options contracts, all opened at roughly the same time, for the same asset, and expiring on the same date:
Iron Condor Options and Iron Butterfly Options:
- 1 long call and 1 long put: A pair of bought call/put options contracts, each representing a collection of shares in the same asset. The long call’s strike price must be set above the current price of the asset, the long put’s strike price must be set below.
- 1 short call and 1 short put: A pair of sold call/put options contracts, each representing a collection of shares in the same asset. The short call’s strike price must be set above the long call, the short put’s strike price must be set below the long put.
What Strategies Are Employed for Both Iron Condor and Iron Butterfly Long/Short Options?
In both Iron Condor and Iron Butterfly strategies, the idea is based on the balance an options holder can maintain between their long and short positions. Typically, the short positions will have their strike prices gathered around the asset’s current sale price while the long positions will have their strike prices set below those of the short positions.
If an underlying asset’s price moves too far from its original position, the risk of capital loss increases on the long options. However, this is counterbalanced by the fact that the short options become increasingly likely to gain capital, effectively placing a cap on the potential for loss. Thus, it is impossible to lose more than the difference between the long options and short options in either an Iron Condor or Iron Butterfly strategy. To make a profit, holders simply sell their short positions and earn from the premiums. Provided that the strike price on the short is closer to the asset’s present price than the long’s strike price, then the holder gains more capital through the short options sales than they spend buying long options.
Essentially, the idea behind both strategies is to always leave higher potential for profit than loss, after which the trader can sit back and let the market play out by itself – while hoping it remains consistent. This is because, as mentioned before, stability increases an Iron Butterfly’s and/or Iron Condor’s success rate.
Iron Butterfly and Iron Condor example graphic, showing the higher maximum potential for capital gains than losses (Sources: optionstradingiq.com (Iron Condor) and wallstreetmojo.com (Iron Butterfly))
The Iron Condor vs. Iron Butterfly: What Are the Differences?
Despite these two options trading strategies being fairly similar, there is one key difference:
- Iron Butterfly: In an Iron Butterfly, strike prices are the same for both short contracts (which is normally set at the current price of the underlying asset).
- Iron Condor: With an Iron Condor, however, strike prices for the two short contracts are set to different values. Generally, one will be set over the underlying asset price and the other under it, with equal value assigned to both the over and the under. However, there are in fact several different ways this can be done (as we will see in the section below).
What Are the Different Forms of the Iron Condor (and Condor) Strategy?
An Iron Condor is one of many similar strategies, all of which use more-or-less the same overarching idea with slight differences, usually based on market prediction, applied. For example, two slight variations are:
- A “bearish” Iron Condor: Where the strike prices are centralized around a point that is lower than the underlying asset’s current price.
- A “bullish” Iron Condor: The same as a bearish Iron Condor but based on a central point that is higher than the asset’s current price.
The reason for these different strategies is that one means that the options holder anticipates that the assets’ value will rise (bullish), while the other anticipates that it will decrease (bearish). Both, however, anticipate that the value of the asset will stabilize again afterwards.
The variations that can be applied to Iron Condors, both bullish and bearish, are almost limitless; as many strategies have doubtless been attempted in the past, with varying amounts of success. Some of the more common variations used by investors are as follows:
- Long Iron Condor: Involves buying one put option with a low strike price and selling another with a lower-middle (bearish) strike price. At the same time, the holder buys a single call option with a higher strike price, while selling another with a high-middle (bullish) strike price. All these options must have the same underlying asset/security and the same expiration date. Generally, the underlying assets’ price rests somewhere between the two middle strike prices, and all four strike prices are equidistant from each other.
- Short Iron Condor: Involves selling one put option with a low strike price and buying another with a lower-middle. At the same time, the holder sells a single call option with a higher strike price, while buying another option with a high-middle. All these options must have the same underlying asset/security, and the same expiration date. Generally, the underlying asset’s price rests somewhere between the two middle strike prices, and all four strike prices are equidistant from each other.
- Reverse Iron Condor: A Reverse Iron Condor (RIC) uses the same put/call option allocation as a short Iron Condor. However, when compared with a normal Iron Condor the distances between the strike prices are inverted, which essentially means that the profitability is capped rather than the risk for loss. Because of this, the profitability margin is often higher than that of a normal Iron Condor. Thus, a RIC is essentially just a more volatile version of an Iron Condor — and generally only used by more savvy traders.
- Condor vs. Iron Condor: A Condor is similar in some ways to an Iron Condor, except that instead of being made up of two call and two put options, all four options are the same (i.e., four put options or four calls). The way Condor spread and Iron Condor spread work is also slightly different— as is the way premiums are used for profit.
Reverse Iron Condor graphic (Source: theoptionsguide.com)
What Effect Do Options and Iron Condors Have on Cryptocurrency Trading?
While cryptocurrency traders are extremely skilled at using futures contracts, many are unaware that there are other financial instruments and strategies designed to help minimize loss, while maximizing profitability. These come in the forms of put/call options contracts, and bullish/bearish Iron Condor strategies (to name a few). However, many crypto investors are oblivious on how to use them and for which situations they are best suited. For those crypto traders expecting fairly average price increases in a month, implementing something like a bullish Iron Condor strategy could potentially net higher gains with little need for upfront capital. This strategy also limits the risk of capital loss. However, it is worth remembering that options contracts are finite, meaning that they have an expiration date. Thus, those expectations must be fulfilled within a predefined period or investors face the risk of loss, however minimized that may be.
To make this a little clearer, below is a simple example of a Bitcoin (BTC) Call Option:
If an investor purchases a call option for BTC at $10,000 that expires in a week, this means that one week later, regardless of where the price is at, they have the option to buy one BTC for $10,000. If the price of BTC has risen to $11,000, they would certainly exercise that right as they could potentially purchase a BTC for a cheaper price and then sell it for a $1,000 profit. If the price has dropped below $10,000, meanwhile, you would simply choose to let the option expire as purchasing a BTC at the strike price would translate to a loss.
It is important to understand that options do not offer investors risk-free methods of crypto derivatives trading. Each option has its own price, called a premium, which varies based on market conditions. So when a trader lets their option expire without exercising their right to buy or sell, they still lose whatever premium they paid for that option.
No form of investment is completely free from risk, however, understanding which strategies to apply and when to apply them can be a method for avoiding that risk. Iron Condors, Iron Butterflies, and their variations can be extremely useful strategies, but only if an investor fully comprehends both the strategy they are using and the market in which they are operating. Precedents have been set that clearly establish the best times to attempt one of these methods, and in what way to attempt them. It is up to each individual investor to analyze the market and its indicators and decide whether the time is right for them, or not.