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Difference Between Iron Butterfly & Iron Condor Strategies

9 Mins 13 Jun 2023 0 COMMENT

What are Iron Butterfly & Iron Condor strategies?

Iron Butterfly and Iron Condor are two option trading strategies that are quite similar in terms of the approach that both profit from short positions. They are direction neutral, which means that two options in one direction are sold and two options in the opposite direction are bought. Such an arrangement helps traders minimize risk, reduce net cost and predict net gains with much better accuracy than a directional trade. These strategies are primarily deployed in low-volatility scenarios and target a price range in order to be successful.

What is Iron Condor?

The Iron condor is a negative-Gamma and negative-Vega option trading strategy. This means that any price change in the underlying asset will trigger an opposite movement in the option price. Iron Condors comprise two short bets and two long bets – all four with the same expiration date. It involves selling both a call spread and a put spread with the same expiration date. The goal is to profit from the time decay of the options and the limited range of the underlying asset’s price movement.

Here’s how the strategy is set up:

  1. Buy 1 OTM Put with Strike price < Current price
  2. Sell 1 OTM Put with Strike price ≤ Current price
  3. Sell 1 OTM Call with Strike price ≥ Current price
  4. Buy 1 OTM Call with Strike price > Current price

All four options should have the same expiration date. The distance between the strike prices of the call spread and the put spread is typically equal, creating a "condor" shape when graphed.

The potential profit of an Iron Condor is the premium received from selling the options, while the maximum loss is the difference between the strikes of either the call spread or the put spread, minus the premium received. The Iron Condor is a popular strategy among options traders because it offers a high probability of success and limited risk.

What is Iron Butterfly?

The Iron Butterfly is a non-directional options trading strategy that involves selling both a call spread and a put spread with the same strike price and expiration date, while also buying an OTM call option and an OTM put option to limit the potential loss. The aim of this strategy is to benefit from a decline in option prices as the OTM put option bought is set at a strike price below the current option price.

Here’s how the setup looks:

  • Sell an at-the-money (ATM) put option.
  • Sell an ATM call option with the same strike price and expiration date.
  • Buy an out-of-the-money (OTM) put option with a lower strike price.
  • Buy an OTM call option with a higher strike price.

Here, one must note that the strike price of the sold call and put options is the same. This strategy has a better risk-reward ratio than the Iron Condor but has a lower probability of yielding a profit.

The potential profit of an Iron Butterfly is the premium received from selling the options, while the maximum loss is the difference between the strikes of either the call spread or the put spread, minus the premium received.

Iron Condor vs Iron Butterfly

The differences in both these strategies are with regards to their construction and the risk involved. The following are the two most distinct differences:

  1. Construction:
    • The Iron Condor’s setup is a combination of a Bear Call Spread and a Bear Put Spread.
    • The Iron Butterfly’s setup is an ATM Short Straddle combined with an OTM Long Strangle.
  1. Risk Involved:
    • The Iron Condor has a wider spread and thus a wider profitable zone, which increases the likelihood of making a profit. However, the profit is not so large.
    • The Iron Butterfly has a narrower spread due to the similar strike prices of the two ATM options. The narrower spread reduces its likelihood of profit, but the potential profit is large.

Let us understand how exactly this inverse relationship between the risk-reward ratio and probability of success works:

An Iron Condor, through its wider spread, distributes its risk further than the Iron Butterfly. Since the Iron Butterfly carries a higher risk, the premiums associated with this strategy are higher. The short bets being closer to the current price command extra gains. The Iron Butterfly can also be used in an extremely volatile situation.

The reduced risk of the Iron Condor thus yields a smaller reward than the Iron Butterfly. The short bets placed significantly below the current price expire worthless at the end, thus yielding low returns overall. However, another way to look at this is that the Iron Condor compensates for reduced gains by throwing in a safety net that reduces the trader’s exposure and accommodates more price volatility than the Iron Butterfly.

Iron Butterfly vs Iron Condor – Which is Better?

Here, it is worth reiterating that both these strategies require the stock price to move within a range. The only difference is that the Iron Condor allows more room for this price movement and thus generates smaller gains in exchange for this flexibility. But the chances of winning here are greater.

Hence, the decision is simple. If you are a risk-averse trader, Iron Condor is the one to pick. Not only will you worry less but you are also likely to make money, no matter how little it may be.

However, if you are willing to push your risk tolerance, then you can deploy the Iron Butterfly. Although you will have lesser wiggle room for price movements, you will stand to make larger gains, despite lower probability.

FAQs on Iron Butterfly vs Iron Condor

Is the Iron Butterfly better than the Iron Condor due to a better risk-reward ratio?

Not necessarily. While the risk-reward ratio is good, the probability of making a profitable trade is lower.

Why the names ‘Iron Condor’ and ‘Iron Butterfly’?

If you look at the payoff diagrams of both these strategies, you will see that their shape resembles the body and wings of the creatures in their names. Hence this christening.