Butterflies & Condors

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Butterflies & Condors

In the last couple posts I talked about vertical spreads in the SPY. A Butterfly or a Condor is a combination of bullish and bearish vertical spreads. There are many variations –

An out of the money bullish position composed of all calls is a “call fly”

An out of the money bearish position composed of all puts is a “put fly”

An at the money neutral position composed of calls & puts is an “iron butterfly”

A butterfly with different but close together short strikes is a “split strike butterfly”

Any of the above with a large distance between short strikes is a “condor” – call condor, put condor & iron condor.

Any of the above with more verticals on one side than the other is the “ratio” version. For example a put fly with 3 long verticals and 2 short verticals is a “ratio put fly”.

Any of the above with one side composed of wider verticals is the “broken wing” version. For example a call condor with a 1 strike wide bullish spread and a 2 strike wide bearish spread is a “broken wing call condor”.

I don’t like any at the money neutral spreads, they take longer to make money & it’s hard to predict that a market will stay range-bound long enough to profit. So all of the “wing spreads” that I trade are out of the money. If you expect a market will move a significant but not great distance & then consolidate for at least several days then a winged spread can work well. The farther you can go out of the money the better they behave, provided that your price assumption is correct.

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On the surface a wing spread is a short Vega position. Meaning that if the demand for options increases the position will suffer so that it would seem to be a bad fit for a bearish index market assumption – but in truth an out of the money wing spread will do well regardless of implied volatility as long as it’s a decent distance out of the money initially and the short strikes aren’t too far apart.

In my next post I’ll illustrated these ideas with a few examples.

Multi-leg Options Positions (Part 3 — Butterflies and Condors)

Butterflies and Condors
So far each of the positions we’ve looked at has still only had 2 legs in it. Now we’ll look at some non directional positions that have 4 different legs in one single position. First iron butterflies and then iron condors.

Before we do that it’s worth quickly mentioning that there is some disagreement about which side to label long and which to label short for iron butterflies and iron condors. The definition we will use in this article is that if the position is established for a net credit (i.e. you receive a premium for opening the whole position) then we’ll consider that selling to open the position and therefore label it the short side. Conversely if the position is established for a net debit (i.e. you pay a premium for opening the whole position) then we’ll consider that buying to open the position and therefore label it the long side.
No matter which way round you label it there is no effect on the P/L, but it’s worth being aware of when conversing with someone about iron condors and iron butterflies to make sure that you both understand which side you are talking about.

One way to think of iron butterflies and iron condors is they are risk defined versions of straddles and strangles respectively.

You can also think of an iron butterfly as a combination of a call spread and a put spread, with the lowest strike in the call spread and the highest strike of the put spread both at strike B.

Opening a Long Iron Butterfly

  • The current price will typically be at or near strike B.
  • You are selling a put at strike A, buying a call and a put at strike B, and selling a call at strike C
  • Your risk is limited to the net debit paid to establish the position.
  • Your position will stop making gains once the price gets down to strike A or up to strike C, so your profit is also limited.
  • This position is similar to a long straddle, but you have limited your maximum profit in exchange for an overall cheaper position due to collecting some premium by selling the put at strike A and the call at strike C.
  • You are longing volatility. You want implied volatility to increase once the position is opened as it will increase the value of your position.
  • Ideally you want the price to expire either below A or above C.

Opening a Short Iron Butterfly

  • The current price will typically be at or near strike B.
  • You are buying a put at strike A, selling a call and a put at strike B, and buying a call at strike C
  • Again your risk and maximum profit are defined.
  • This position is similar to a short straddle, but you have limited your risk by purchasing the OTM options at strike A and C.
  • You are shorting volatility. You want implied volatility to decrease once the position is opened as this will decrease the value of the options you have sold. A sideways ranging market would be ideal for you.
  • Ideally you want the price to expire at strike B

Bitcoin Iron Butterfly Example
Using the spreadsheet I have constructed both a long and short iron butterfly.
The long iron butterfly consists of the following legs:
-1 put with a strike price of 3000 and price of 0.05BTC
+1 put with a strike price of 3500 and price of 0.1BTC
+1 call with a strike price of 3500 and price of 0.1BTC
-1 call with a strike price of 4000 and a price of 0.05BTC

The short iron butterfly consists of the following legs:
+1 put with a strike price of 3000 and price of 0.05BTC
-1 put with a strike price of 3500 and price of 0.1BTC
-1 call with a strike price of 3500 and price of 0.1BTC
+1 call with a strike price of 4000 and a price of 0.05BTC

The middle two options in bold are the same as the straddle from part 1, and the other two options are called the wings. These are the legs that turn it into an iron butterfly, defining the risk for sellers and profit for buyers.

This example will be left in the downloadable version of the sheet under the name ‘Iron Butterfly’.

Compared to the long straddle the long iron butterfly is considerably cheaper for the buyer meaning the max loss is lower and a much smaller move is needed to get to breakeven, the obvious trade off being that the profit in both directions is now capped.

Compared to the short straddle the short iron butterfly has the benefit of having defined the risk in both directions for the seller (in USD at least). The trade off being of course the premium collected is lower.

Here I’ve plotted the short butterfly as above (in red) and the corresponding short straddle (in blue) for visual comparison.

An iron condor is very similar to an iron butterfly in that it is a combination of a call spread and a put spread, but this time they do not overlap creating a wider range. You can also think of it as a strangle with wings that define the risk (or reward for buyers).

Opening a Long Iron Condor

  • The current price will typically be between strikes B and C.
  • You are selling a put at strike A, buying a put at strike B, buying a call at strike C, and selling a call at strike D
  • Your risk is limited to the net debit paid to establish the position.
  • Your position will stop making gains once the price gets down to strike A or up to strike D, so your profit is also limited.
  • This position is similar to a long strangle, but you have limited your maximum profit in exchange for an overall cheaper position due to collecting some premium by selling the put at strike A and the call at strike D.
  • You are longing volatility. You want implied volatility to increase once the position is opened as it will increase the value of your position.
  • You want the price to expire either below A or above D.

Opening a Short Iron Condor

  • The current price will typically be between strikes B and C.
  • You are buying a put at strike A, selling a put at strike B, selling a call at strike C, and buying a call at strike D
  • Again your risk and maximum profit are defined.
  • This position is similar to a short strangle, but you have limited your risk by purchasing the options at strikes A and D.
  • You are shorting volatility. You want implied volatility to decrease once the position is opened as this will decrease the value of the position you have sold. A sideways ranging market would be ideal for you.
  • Ideally you want the price to expire between strikes B and C.

Bitcoin Iron Condor Example
Using the spreadsheet I have constructed both a long and short iron condor.
The long iron condor consists of the following legs:
-1 put with a strike price of 2500 and a price of 0.05BTC
+1 put with a strike price of 3000 and a price of 0.1BTC
+1 call with a strike price of 3500 and a price of 0.1BTC
-1 call with a strike price of 4000 and a price of 0.05BTC

The short iron condor consists of the following legs:
+1 put with a strike price of 2500 and a price of 0.05BTC
-1 put with a strike price of 3000 and a price of 0.1BTC
-1 call with a strike price of 3500 and a price of 0.1BTC
+1 call with a strike price of 4000 and a price of 0.05BTC

The middle two options in bold are a strangle, and the other two options are called the wings. These are the legs that turn it into an iron condor, defining the risk for sellers and profit for buyers.

This example will be left in the downloadable version of the sheet under the name ‘Iron Condor’.

Compared to the long strangle the long iron condor is considerably cheaper for the buyer meaning the max loss is lower and a much smaller move is needed to get to breakeven, the obvious trade off being that the profit in both directions is now capped.

Compared to the short strangle the short iron condor has the benefit of having defined the risk in both directions for the seller (in USD at least). The trade off being of course the premium collected is lower.

Constructing Butterflies and Condors Using Different Options

In the put spread section earlier we touched on how the USD P/L of a short call spread looks identical to a long put spread, and a long call spread looks identical to a short put spread. As a corollary to this it is possible to construct both butterflies and condors using solely calls, or solely puts.

I won’t go through all the permutations or it will result in unnecessary repetition, but as one example I have constructed here in the spreadsheet an example of a regular short iron condor (in blue) and a condor using only puts (in red).

As you can see in USD terms this has no effect on the P/L (the slight difference only there due to the prices I’ve chosen so you can see both lines), however it does change the shape of the BTC chart. This kind of example can sometimes be very useful when making sure your position’s payoff aligns with what you want in terms of BTC.

Next Up: Option Pricing and Implied Volatility
There are still a few other multi leg positions that skew the P/L in different directions and have their own pros and cons, essentially moving potential profit from one area of the chart to another. We’ll come back to those eventually but it’s about time we starting diving into options pricing and implied volatility, which we will do in the next article.

Before we move onto the price you manage to get for each leg of a position, everything on these profit and loss charts that we’ve been looking at so far is a trade off. If you make one part of the chart more profitable then you must sacrifice profit somewhere else, if you are willing to have higher risk in one direction, you can make a larger profit in the other etc.

I would strongly advise having a play around in the sheet by adding different combinations of options and even adding in futures longs and shorts to see what effect these have. It’s a great way to learn and will help you be able to visualise things without the need to keep referencing back to articles or websites for each position while you’re trading. This will allow you to choose the right position for your outlook on the market more easily.

If you have any questions at all feel free to comment on here, hit me up on twitter @cryptarbitrage or in the Deribit telegram chat here: https://t.me/deribit

If you are new to Deribit you can take a look and sign up here: Visit Deribit

Butterfly Spread

What Is a Butterfly Spread?

A butterfly spread is an options strategy combining bull and bear spreads, with a fixed risk and capped profit. These spreads, involving either four calls or four puts are intended as a market-neutral strategy and pay off the most if the underlying does not move prior to option expiration.

Key Takeaways

  • There are multiple butterfly spreads, all using four options.
  • All butterfly spreads use three different strike prices.
  • The upper and lower strike prices are equal distance from the middle, or at-the-money, strike price.
  • Each type of butterfly has a maximum profit and a maximum loss.

Understanding Butterflies

Butterfly spreads use four option contracts with the same expiration but three different strike prices. A higher strike price, an at-the-money strike price, and a lower strike price. The options with the higher and lower strike prices are the same distance from the at-the-money options. If the at-the-money options have a strike price of $60, the upper and lower options should have strike prices equal dollar amounts above and below $60. At $55 and $65, for example, as these strikes are both $5 away from $60.

Puts or calls can be used for a butterfly spread. Combining the options in various ways will create different types of butterfly spreads, each designed to either profit from volatility or low volatility.

Long Call Butterfly

The long butterfly call spread is created by buying one in-the-money call option with a low strike price, writing two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. Net debt is created when entering the trade.

The maximum profit is achieved if the price of the underlying at expiration is the same as the written calls. The max profit is equal to the strike of the written option, less the strike of the lower call, premiums, and commissions paid. The maximum loss is the initial cost of the premiums paid, plus commissions.

Short Call Butterfly

The short butterfly spread is created by selling one in-the-money call option with a lower strike price, buying two at-the-money call options, and selling an out-of-the-money call option at a higher strike price. A net credit is created when entering the position. This position maximizes its profit if the price of the underlying is above or the upper strike or below the lower strike at expiry.

The maximum profit is equal to the initial premium received, less the price of commissions. The maximum loss is the strike price of the bought call minus the lower strike price, less the premiums received.

Long Put Butterfly

The long put butterfly spread is created by buying one put with a lower strike price, selling two at-the-money puts, and buying a put with a higher strike price. Net debt is created when entering the position. Like the long call butterfly, this position has a maximum profit when the underlying stays at the strike price of the middle options.

The maximum profit is equal to the higher strike price minus the strike of the sold put, less the premium paid. The maximum loss of the trade is limited to the initial premiums and commissions paid.

Short Put Butterfly

The short put butterfly spread is created by writing one out-of-the-money put option with a low strike price, buying two at-the-money puts, and writing an in-the-money put option at a higher strike price. This strategy realizes its maximum profit if the price of the underlying is above the upper strike or below the lower strike price at expiration.

The maximum profit for the strategy is the premiums received. The maximum loss is the higher strike price minus the strike of the bought put, less the premiums received.

Iron Butterfly

The iron butterfly spread is created by buying an out-of-the-money put option with a lower strike price, writing an at-the-money put option, writing an at-the-money call option, and buying an out-of-the-money call option with a higher strike price. The result is a trade with a net credit that’s best suited for lower volatility scenarios. The maximum profit occurs if the underlying stays at the middle strike price.

The maximum profit is the premiums received. The maximum loss is the strike price of the bought call minus the strike price of the written call, less the premiums received.

Reverse Iron Butterfly

The reverse iron butterfly spread is created by writing an out-of-the-money put at a lower strike price, buying an at-the-money put, buying an at-the-money call, and writing an out-of-the-money call at a higher strike price. This creates a net debit trade that’s best suited for high-volatility scenarios. Maximum profit occurs when the price of the underlying moves above or below the upper or lower strike prices.

The strategy’s risk is limited to the premium paid to attain the position. The maximum profit is the strike price of the written call minus the strike of the bought call, less the premiums paid.

Example of a Long Call Butterfly

An investor believes that Verizon stock, currently trading at $60 will not move significantly over the next several months. They choose to implement a long call butterfly spread to potentially profit if the price stays where it is.

An investor writes two call options on Verizon at a strike price of $60, and also buys two additional calls at $55 and $65.

In this scenario, an investor would make the maximum profit if Verizon stock is priced at $60 at expiration. If Verizon is below $55 at expiration, or above $65, the investor would realize their maximum loss, which would be the cost of buying the two wing call options (the higher and lower strike) reduced by the proceeds of selling the two middle strike options.

If the underlying asset is priced between $55 and $65, a loss or profit may occur. The amount of premium paid to enter the position is key. Assume that it costs $2.50 to enter the position. Based on that, if Verizon is priced anywhere below $60 minus $2.50, the position would experience a loss. The same holds true if the underlying asset were priced at $60 plus $2.50 at expiration. In this scenario, the position would profit if the underlying asset is priced anywhere between $57.50 and $62.50 at expiration.

This scenario does not include the cost of commissions, which can add up when trading multiple options.

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