By Pat Crawley
It's a core tenant of how options are priced, and it's often the trader with the most accurate volatility forecast who wins in the long term.
Whether you like it or not, you're taking an inherent view on volatility anytime you buy or sell an option. By purchasing an option, you're saying that volatility (or how much the options market thinks the underlying will move until expiration) is cheap, and vice versa.
With volatility as a cornerstone, some traders prefer to do away with forecasting price directionality entirely and instead trade based on the ebbs and flows of volatility in a market-neutral fashion.
Several option spreads enable such market-neutral trading, with strangles and straddles being the building blocks of volatility trading.
But even though straddles and strangles are the standards, they sometimes leave something to be desired for traders who want to express a more nuanced market view or limit their exposure.
For this reason, spreads like iron condors and butterflies exist, letting traders bet on changes in options market volatility with modified risk parameters.
Today, we’ll be talking about the iron condor, one of the most misunderstood options spreads, and the situations where a trader may want to use an iron condor in favor of the short strangle.
What is a Short Strangle?
Before we expand on the iron condor and what makes it tick, let's start by going over the short strangle, a short-volatility strategy that many view as the building blocks for an iron condor. An iron condor is essentially just a hedged short strangle, so it's worth understanding them.
A strangle comprises an out-of-the-money put and an OTM call, both in the same expiration. A long strangle involves buying these two options, while a short strangle involves selling them. The goal of the trade is to make a bet on changes in volatility without taking an outright view on price direction.
As said, strangles and straddles are the building blocks for options volatility trading. More complex spreads are constructed using a combination of strangles, straddles, and "wings," which we'll explore later in the article.
Here’s an example of a textbook short strangle:
The goal for this trade is for the underlying to trade within the 395-405 range. Should this occur, both options expire worthless, and you pocket the entire credit you collected when you opened the trade.
However, as you can see, you begin to rack up losses as the market strays outside of that shaded gray area. You can easily calculate your break-even level by adding the credit of the trade to each of your strikes.
In this case, you collect $10.46 for opening this trade, so your break-even levels are 415.46 and 384.54.
But here's where the potential issue arises. As you can see, the possible loss in this trade is undefined. Should the underlying go haywire, there's no telling where it could be by expiration. And you'd be on the hook for all of those losses.
For this reason, some traders look to spreads like the iron condor, which lets you bet on volatility in a market-neutral fashion while defining your maximum risk on the trade.
Iron Condors Are Strangles With “Wings”
Iron condors are market-neutral options spreads used to bet on changes in volatility. A key advantage of iron condors is their defined-risk property compared with strangles or straddles. The unlimited risk of selling strangles or straddles is
Iron condors are excellent alternatives for traders who don't have the temperament or margin to sell straddles or strangles.
The spread is made up of four contracts; two calls and two puts. To simplify, let's create a hypothetical. Our underlying SPY is at 400. Perhaps we think implied volatility is too high and want to sell some options to take advantage of this.
We can start by constructing a 0.30 delta straddle for this underlying. Let's use the same example: selling the 412 calls and the 388 puts. We're presented with the same payoff diagram as above. We like that we're collecting some hefty premiums, but we don't like that undefined risk.
Without putting labels on anything, what would be the easiest way to cap the risk of this straddle? A put and a call that is both deeper out-of-the-money than our straddle. That's pretty easy. We can just buy further out-of-the-money options. This is all an iron condor is, a straddle with "wings."
Another way of looking at iron condors is that you’re constructing two vertical credit spreads. After all, if we cut the payoff diagram of an iron condor in half, it’s identical to a vertical spread:
Here’s what a standard iron condor might look like when the underlying price is at 400:
● BUY 375 put
● SELL 388 put
● SELL 412 call
● BUY 425 call
The payoff diagram looks like this:
The Decision To Use Iron Condors vs. Short Strangles
Ever wonder why the majority of professional options traders tend to be net sellers of options, even when on the face of things, it looks like you can make huge home runs buying options?
Many natural customers in the options market use them to hedge the downside in their portfolios, whether that involves buying puts or calls.
They essentially use options as a form of insurance, just like a homeowner in Florida buys hurricane insurance not because it's a profitable bet but because they're willing to overpay a bit for the peace of mind that their life won't be turned upside down by a hurricane.
Many option buyers (not all!) operate similarly. They buy puts on the S&P 500 to protect their equity portfolio, and they hope the puts expire worthless, just as the Florida homeowner prays they never have actually to use their hurricane insurance.
This behavioral bias in the options market results from a market anomaly known as the volatility risk premium. All that means is implied volatility tends to be higher than realized volatility. And hence, net sellers of options can strategically make trades to exploit and profit from this anomaly.
There's a caveat, however. Any source of returns that exists has some drawback, a return profile that perhaps isn't ideal in exchange for earning a return over your benchmark. With selling options, the risk profile scares people away from harvesting these returns.
As you know, selling options has theoretically unlimited risk. It's critical to remember that when selling a call, you're selling someone else the right to buy the underlying stock at the strike price. A stock can go up to infinity, and you're on the hook to fulfill your side of the deal no matter how high it goes.
So while there can be a positive expected value way to trade from the short side, many aren’t willing to take that massive, undefined risk.
And that's where spreads like the Iron Condor come in. The additional out-of-the-money puts and calls, often referred to as 'wings,' cap your losses, allowing you to short volatility without the potential for catastrophe.
But it's not a free lunch. You're sacrificing potential profits to assure safety from catastrophic loss by purchasing those two OTM options. And for many traders, this is too high a cost to harvest the VRP.
In nearly any, backtest or simulation, short strangles come up as the clear winner because hedging is generally -EV. For instance, take this CBOE index that tracks the performance of a portfolio of one-month .15/.05 delta iron condors on SPX since 1986:
Furthermore, there's the consideration of commissions. Iron condors are made up of four contracts, two puts, and two calls. This means that iron condor commissions are double that of short strangles under most options trading commission models.
With the entry-rate retail options trading commission hovering around $0.60/per contract, that’s $4.80 to open and close an iron condor.
This is quite an obstacle, as most iron condors have pretty low max profits, meaning that commissions can often exceed 5% of max profit, which has a big effect on your bottom line expected value.
Ultimately, it costs you in terms of expected value and additional commissions to put on iron condors. So you should have a compelling reason to trade iron condors in favor of short strangles.
Too many traders get stuck in the mindset of "I'm an iron condor income trader" when the market is far too chaotic and dynamic for such a static approach. The reality is that there's an ideal strategy for risk tolerance at a given time, in a given underlying.
Sometimes the overall market regime calls for a short-volatility strategy, while others call for more nuanced approaches like a calendar spread.
There are times when it makes sense to trade iron condors when implied volatility is extremely high, for instance. High enough that any short-vol strategy will print money, but too high to be naked short options. Likewise, there are times when iron condors are far from the ideal spread to trade.
Another comparison is Iron Condor Vs. Iron Butterfly
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Such lawsuits are common and typically lack merit because offering documents are properly drafted to protect the companies involved and disclose the risk.
I find it unlikely that the documents were not properly drafted. For instance, in one of the few actual UBS documents I could find on UBS’s yield enhancement strategies provided “yield enhancement strategy products are designed for investors with moderate risk tolerance who want to enhance the low to moderate return typically generated in a ‘flat’ or ‘sideways’ market.” That’s a great description for trading iron condors.
So, if the documents were fine (most likely, but you never know), what was the issue?Most likely overzealous brokers pushed the strategy without really understanding the risk profile.
My takeaway from reading about this is two part. First, investors typically don’t understand options, and the media certainly does not. Most advisors do not either. For instance, the media has called the strategy used by UBS a “leveraged, esoteric options strategy.” Iron condors are neither esotericor typically leveraged. They are the definition of a defined risk option strategy. A profit/loss graph of an iron condor looks like:
There is a maximum loss on any single trade that can be controlled based on the strikes and premiums received. UBS’s strategy purportedly used iron condors on the S&P 500 index, the NASDAQ, and other “primary” market indexes – so volume should not have been an issue.
Other writers have demonstrated their ignorance of the strategy. One popular critique of the UBS strategy reads:
“The problems with YES began in 2018 with violent fluctuations in the S&P 500…The most volatile period was between October and December 2018, during which time the market declined 20%--then followed by a rebound of 12% through January 2019. The violent swings caused the premiums of both the put and call side of the iron condor strategy to spike, leading to losses on both sides of the trade.”
But this is practically impossible. An investor can’t experience losses on BOTH sides of the graph (in effect doubling the losses), unless the traders are idiots. The only way to have that happen is to close out one half of the trade for a loss, in the hopes that the profits on the other side will increase, but then the market whipsaws back, thus causing losses on both sides.
Of course, at this point, the strategy is no longer an iron condor. It’s a simple vertical spread:
The odd thing about this critique is that even vertical spreads have loss limits. Let’s say the UBS traders had a maximum loss rate of ten percent. A structured iron condor can have a max loss of ten percent the same as a vertical spread.
If the traders are trading to profit from time decay across multiple indexes, risk could be further controlled through the use of reverse iron condors that have a profit and loss graph of:
In the event of a large move, such a position could help offset losses. (There are other ways to protect against such a move as well – anything from simply buying long dated out of the money puts and calls to trading volatility instruments).
The problem with a normal iron condor in a low volatility market is that traders do not receive a very high premium for the risk they take. In order to get a 1% or 2% return per month, UBS traders would have to be taking risks that were outside of the “moderate” or “low” range. Traders probably started taking chances they shouldn’t have.
Much of the media has commented that the UBS traders “compounded” their results by trying to “make up” for losses after blowing up trades. (Who of us hasn’t done that?) Traders make trade adjustments or open new trades on the prediction that either (a) the price will return to the mean or (b) the price will continue moving. It appears the UBS traders made the bet that the price would continue moving, and instead it reverted to the mean.
Of course,when traders do that, they are no longer trading risk defined iron condors. They are making directional market bets – bets that if wrong, make the situation worse.
What can we, as option traders, learn from this?
Trading is as much psychological, as it is methodical, even for supposed professionals. Losses will occur and decisions will be made trying to “make up” for losses rather than staying within stated trading guidelines. This is a mistake. Plan trades, plan for what happens when the trades go wrong, and when they do go wrong, stick to the plan. Sure you might occasionally “fix” what went wrong, but more often than not, you’ll likely make the situation worse; The general public views option as “high risk” investments. They are not, when handled properly. In fact, as option traders know, options can be used to mitigate risk. Try to combat the disinformation when you can; Don’t trust plaintiff class action lawyers.
I personally do not understand all of the class type legal advertising that exists because of the strategy. By all accounts, all UBS agreements require FINRA arbitration of individual claims. This greatly decreases the profit potential for attorneys, unless the client lost hundreds of thousands of dollars (in which case the client is probably not calling Saul from the internet for the case). Strangely, that is what can currently be seen.
Christopher Welsh is a licensed investment advisor and president of LorintineCapital, LP. He provides investment advice to clients all over the United States and around the world. Christopher has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Christopher has a J.D. from the SMU Dedman School of Law, a Bachelor of Science in Computer Science, and a Bachelor of Science in Economics. Christopher is a regular contributor to the Steady Options Anchor Trades and Lorintine CapitalBlog.
By Mark Wolfinger
The truth is that selling straddles is a strategy that seeks a high profit and it must come with significant risk.
When you are naked short options, loss is theoretically unlimited – and there's nothing to be done about that. Sure, we know there will not be a 50% one-day rally, nor will there be a one-day 75% decline. But they are theoretically possible and that makes it impossible to estimate the maximum loss for the straddle.
If willing to live with the risk of a gigantic loss, then you may be comfortable selling straddles. However, because you are asking about risk reduction, I assume that unlimited loss is something you prefer to avoid.
Iron Condor vs. Straddle
The best (in my opinion) protection is to buy a put that is farther OTM than your short put. In other words, I am willing to pay that very high price for the put because it provides complete protection against a huge gap opening – or any significant move. By 'complete protection' I mean it establishes a maximum possible loss. When you have the ability to set that loss potential, you are in position to trade more effectively.
For example, when you recognize the worst possible result, you are better able to size the trade properly. Translation: You can make a very good judgement about how many contracts to trade. When selling straddles, there is no good method to allow effective money management.
Note the difference: You can manage risk by adjusting positions as needed – assuming that there is no large market gap. However, there is no way to practice sound money management money when you don't have a good estimate of how much is at risk.
Yes, this is very expensive, reduces potential profits significantly and converts the straddle into an iron condor (assuming you do this on both the put and call sides). However, it does allow you to have a better handle on money management and risk management.
If you fear, or anticipate a market decline, you can take out partial insurance right now – when initiating the position. There is nothing magical about selling straddles, and you can trade a strangle instead. In this scenario, you would sell the 1185 call, as planned, but could choose a lower strike put. Perhaps the 1165 or the 1150 put? The point is that you build in your market bias by making a small (not 100 points) adjustment in the strike prices of the options sold.
I've been trading options since 1975 and have come to one major risk management rule that suits my comfort zone. I no longer sell any naked options (unless I want to buy stock and elect to sell a naked put in an attempt to buy stock at a lower price). I have incurred too many large losses from being short far too many naked options – both calls and puts. I am NOT telling you to adopt that same limitation. What I am doing is asking you to consider the risk of selling straddles and decide if it works for you. It may be a perfect (high risk) strategy for your trading style.
a) Buying debit spreads (puts in your example) is far less costly and provides far less protection than buying single options. And that protection is limited. But if there is no huge gap, this is a very useful method to reduce risk.
I'd prefer not to constantly use the phrase 'if there is no gap,' but the truth is, that's the big, ugly enemy for the naked call or put seller. That gap eliminates the opportunity to make a timely adjustment before disaster occurs.
b) Another risk management method to consider is to reduce the time that you own the short straddle position. True, the most rapid time decay comes near expiration, but if you take the extra risk associated with selling naked options, you can counter some of that risk by not holding into expiration. Consider owning the position for only two or three weeks, taking the profit, and waiting patiently until it's time to open a new straddle. Being out of the market is one sure method for reducing risk.
c) Other solutions exist, but buying single options or debit spreads represent the most simple and effective choices.
Another example is an OTM put backspread. But please be warned: The risk graph may look very good today and you may feel adequately protected today, but the passage of time turns these into situations in which you may incur a big loss from the original straddle plus another from the back spread.
Buy some SPX Dec 1120 puts and sell fewer SPX Dec 1130 puts. Because you own extra options, the gigantic downside move will not hurt. However, if SPX declines and moves near 1120 as expiration arrives, this backspread can lose big money.
This is not the appropriate time to go into a further description of the backspread, but some of the problems are mentioned in this post.
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By Pat Crawley
They're selling options to traders looking for big wins, and when those options expire worthless, the seller of the option gets to keep the premium he collected.
Many traders use these spreads to trade range-bound markets, where there’s a sustained technical range with well-defined support and resistance levels. These are winning trades should the market remain within the defined range through the life of the trade.
While Iron Condors and Iron Butterflies both take advantage of the same market dynamics, there are situations where it makes sense to use one over the other.
Selling Options: Shorting Volatility
Both Iron Condors and Iron Butterflies are non-directional, limited risk option spreads. Instead of trying to profit by being bullish or bearish, these option spreads are tools to make money from options you think will expire worthless.
If you had the chance to look at the options market during the GameStop madness in 2021, you witnessed insane option prices. So many traders wanted to bet against the stock but didn't want to get destroyed in a short squeeze, so they preferred to buy puts. This made put options insanely expensive to the point where you could be right on the trade and still lose money.
As a result, selling puts was a prevalent strategy to take advantage of overpriced options. These situations occur every day to varying degrees.
When you short an option, you're selling it to another buyer. For example, let's say you sell a call with a strike price of $20 on a $15 stock for $1. The stock is still at $15 at expiration, and the option expires worthless. You get to keep the entire $1.
It's well-known that most options expire worthless, so this is a compelling trade to many traders. However, the downside is your unlimited risk when shorting options. Suppose the stock in the example above was $30 at expiration. The option is now worth $15, and you're $14 in the hole.
For this reason, many traders use spreads like Iron Condors and Iron Butterflies to cap their downside. These spreads involve shorting options but buying further OTM options to limit risk.
What is an Iron Condor?
If you're familiar with other options spreads, an iron condor combines a short vertical call spread and a short vertical put spread. Put another way, it's a short strangle where you buy "wings" (OTM options) to cap your downside.
If you're unfamiliar with the dictionary full of the lingo we options traders use, an Iron Condor involves shorting an out-of-the-money (OTM) put and call and buying a further OTM put and call.
These extra OTM options we buy are used to cap our downside. Because shorting options comes with an unlimited downside, the Iron Condor has the benefits of shorting options with the added benefit of limiting our downside.
An iron condor is an option spread that involves using options to profit from a stock staying within a certain price range. Put simply, the iron condor enables traders to make profits even when a stock doesn’t move at all.
The iron condor is composed of four options, a long put and call, and a short put and call. Here’s an example of an iron condor spread:
BUY (1) 394 PUT SELL (1) 400 PUT SELL (1) 420 CALL BUY (1) 426 CALL
As you can see, you’re selling an inner options spread, and protecting the unlimited loss by buying cheap out-of-the-money (OTM) “wings” that backstop the losses if your trade idea is wrong.
Here’s what the payoff diagram for this trade looks like:
The goal of this option spread is for the underlying stock price to remain within the range you define with your short strikes. Because we’re selling a $400 strike put and $420 strike call, we want the stock to trade within that price range. Should it remain inside this range, we make our maximum profit at expiration because the options expire worthless.
However, as you can see, our long OTM options cap our downside, mitigating the biggest risk of selling options: the unlimited losses. Of course, because there’s no free lunch, this costs us money because we have to buy options that we hope ultimately expire worthless.
Characteristics of the Iron Condor
The Iron Condor is Market Neutral
The iron condor is market neutral, meaning it doesn’t take a directional price view, and instead profits from the lack of directional price movement. Traders often refer to this characteristic as “short volatility” because you’re betting that the stock price will move less than the options market is pricing in.
You would use an iron condor when you expect the underlying stock to stay within a tight trading range and not bounce around a lot.
The Iron Condor is a Theta Decay Strategy
Because iron condors collect a net credit and are hence net short options, it is a positive theta strategy, meaning it benefits from the passage of time.
Iron Condor Payoff and P&L Characteristics
Iron condors have limited maximum profit potential as well as a limited maximum loss.
The maximum profit is equivalent to the net credit collected from initiating the trade. You can easily calculate this by subtracting the cost of your long OTM wings from your short options.
Let’s use our previous example:
BUY (1) 394 PUT @ 2.28 SELL (1) 400 PUT @ 3.20 SELL (1) 420 CALL @ 3.45 BUY (1) 426 CALL @ 1.47
First, let’s sum the prices of our short options.
Our 400 put costs $3.20 and our $420 call costs $3.45, meaning we collect $6.65 for selling these two options.
Then, we simply add together the price of our long options, giving us a debit outlay of $1.47 + $2.28 = $3.75.
Now we just subtract the debit from our credit to find our net credit, $6.65 - $3.75 = $2.90. Our maximum profit is $2.90
The maximum loss of an iron condor is simply the “wing width” minus the net credit received. Wing width refers to the distance between the strike prices two calls or two puts. In this case, we’d just subtract the 426 call from the 420 call, giving us a wing width for $6. Now we just subtract our net credit of $2.90 giving us a max loss of $3.10.
Iron Condor Pros and Cons
Pro: Low Capital Requirements
Because the iron condor is a limited risk strategy, you can execute it with significantly less margin than selling the equivalent short strangle (which is the same trade, except without the long OTM options capping your losses). This makes it a very popular way for undercapitalized traders to harvest premium.
Pro: Structure Trades With High Probability of Profit and No Huge Downside
Many option traders approach the market with a systematically short-volatility positioning. They’re constantly selling options and rolling them out further if the trade goes against them. This is a strategy that can print money for a long time until you’re on the wrong side of a volatility event. Many traders, like James Cordier of OptionSellers.com have blown up as a result.
For this reason, some traders take a similar approach using iron condors, avoiding catastrophic losses. However, this strategy has significant drawbacks as you’re harvesting significantly less premium because you’re buying the OTM options and reducing your net credit.
Con: High Commission Costs
The iron condor requires four options per spread, making it twice as expensive to trade compared to most two-option spreads like straddles, strangles, and vertical spreads. Unlike the stock market, where commissions are zero across all retail brokers, option commissions still leave a dent in your P&L, with the standard introductory rate being $0.60/contract, which you have to pay to both open and close, bringing it to $1.20 per contract.
So even for a one-lot, you’re paying $4.80 to open and close an iron condor, which is typically structured with a low maximum profit, meaning that your commissions can be a hefty percentage of your P&L when trading iron condors.
Con: Less Liquidity
The combination of requiring simultaneous execution of four different option contacts usually means it takes longer to get filled on these trades, making active trading more difficult.
What is an Iron Butterfly?
The Iron Butterfly is like an Iron Condo with a higher reward/risk ratio but a lower probability of profit.
The primary difference is the short strikes. In choosing your strikes in an Iron Condor or Iron Butterfly trade, you’re defining the range you expect the underlying to remain within.
Iron Condors are more forgiving, as that range is much wider. Iron Butterflies, on the other hand, short puts and calls at the same strike, making your defined range narrower and making it less likely that you'll profit on the trade. You will, however make more money if you're right on the trade.
Iron butterflies and iron condors are sisters. They express very similar market views and are structured similarly. The primary difference in practice is that the iron butterfly is a far more precise strategy. It’s harder to be right, but if you are right, you make much more money.
The iron butterfly is composed of four options: two long options and two short options at the same strike. Here’s an example:
BUY (1) 404 Put SELL (1) 412 put SELL (1) 412 call BUY (1) 420 call And here’s what the payoff diagram for this trade looks like:
As you can see, the character of the trade is quite similar to the iron condor except for the fact that it has a more narrow opportunity to make profit. However, when the trade is in-the-money, the profits are much higher.
So while most iron condors have relatively low reward/risk ratios and high win rates, iron butterflies are the opposite. They have a lower chance of success with a much higher reward/risk ratio.
In this way, you can have the same view (the market will stay within a relatively tight range) and structure dramatically different trades around it. The iron condor will probably work out and net you a small profit, while the iron butterfly is a more confident approach giving you the chance for fatter profits.
Like everything in options trading, it’s all about tradeoffs.
Characteristics of the Iron Butterfly
The Iron Butterfly is Market Neutral
Just like the iron condor, short strangle, and short straddle, the iron butterfly has no directional price bias. It doesn’t care which direction the underlying stock moves. Instead, the iron butterfly is concerned with the magnitude of the price move. It profits when the underlying stock stays within a narrow range and doesn’t make any significant price moves.
Due to the iron butterfly using just one short strike, the underlying stock must stay in a much more narrow range than with the iron condor. Whereas the iron condor has the freedom to define a wide range using a short put and call, the iron butterfly is short only one strike, leading to the cone-shaped payoff diagram.
For this reason, the maximum profit is much higher with the caveat that the probability of reaching the maximum profit is far lower than that of the iron condor.
In this way, the iron butterfly enables you to express a market-neutral and short-volatility market outlook with a high reward/risk ratio that would usually be a trait of a net debit strategy.
The Iron Butterfly is a Theta Decay Strategy
The goal of the iron butterfly strategy is for the short option to expire worthless, or at least with less value than you initially sold it for.
As with any short options strategy, much of the profit comes from the stock price not moving, resulting in the option rapidly losing time value due to theta decay.
Iron condors capitalize on the same phenomenon but with a different trade structure.
The Iron Butterfly Has Limited Profit and Risk Potential
The max profit and loss math for the iron butterfly is quite similar to that of the iron butterfly.
The max profit is the net credit received when opening the position
The max loss math works similarly to simply shorting a call or put. The further away the stock is from the strike price, the more the losses build until your long option hedges kick in and cap the losses.
Iron Butterfly Pros and Cons
Pro: Short Volatility With High Reward/Risk Ratio
In general, market-neutral strategies that capitalize on theta decay tend to have poor reward/risk ratios, only making up for this drawback with a high win rate. The iron butterfly turns this on its head and instead has a much lower win rate than traditional short-volatility strategies with a higher reward/risk ratio, giving you the potential for asymmetric profits.
Pro: Selling Options With Limited Risk
For many traders who lean towards selling premium, the potential for unlimited, catastrophic losses keeps them up at night. Despite the low probability of an extreme price move, black swans seem to creep up more than anyone expects.
The iron butterfly allows traders to mimic the payoff structure of simply selling a put or call while capping losses with long options on either side of their short option strike.
Con: Narrow Range of Profitability
An iron butterfly has a narrow range of profitability compared to the iron condor because there is only one short strike. This means there’s a far greater margin of error for strike selection, whereas the iron condor allows you to choose two strikes and define as wide of a range as you’d like.
Iron Condors are made up of both a short vertical spread and a short vertical put spread.
Iron Butterflies are made up of two short options at the same strike and two long "wings" that protect your downside.
Remember that option spreads are trade constructions, not trade strategies. There's no inherent edge in trading Iron Condors or Iron Butterflies. They're just tools to apply to market dynamics where its more likely for markets to stay range-bound.
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By Mark Wolfinger
I plan to reply to each question and will group them as part of the Trader Mindset Series. Taken together, they represent how one trading professional, but psychology amateur, views the psychology of how trader's think.
Are You Asking The Right Questions?
I understand the thought process behind today's question, but it always disturbs me. It's just the wrong question. It would be better to ask any of these:
How much time should I expect to devote to my options education before expecting to earn money? How much cash do I need before opening an options trading account? Do most new option traders find success? Or do most give up? I've never traded stocks or anything else. Will that make it difficult to learn to trade options? Should I learn to trade options or pay someone else to trade for me? These questions demonstrate that the person who wants to become an options trader recognizes that this is not a gimmie, and that some time and effort must be expended before rewards can be expected. The commonly asked question: 'How much can I earn?' suggests to me that the person asking 'knows' success is easy, and that the only thing holding him/her back from joining the game is wondering whether it's worthwhile.
I seldom, if ever, receive a question along these lines: 'What does it take to succeed?' It's always similar to: 'I'm going to succeed. How much can I make?'
A recent letter from Jo:
Is it possible for an ordinary person to generate income from trading options if they are able to sustain themselves for a few months without a job while they learn the ropes? How much can one hope to earn through trading options on the conservative side, and how long does it take to become an expert on average? Is it necessary to purchase special software for options trading (technical indicators and such)?
Yes. It can be done. You can generate income. However, when you 'need' the money for living expenses, it often places too much pressure on the investor/trader to succeed, and succeed right now. That added pressure can will lead to poor trading decisions. I know you understand. And that's why you plan to have 'a few months' cash in reserve.
The good news is that you recognize that profits do not begin from day one. The not so good news is that you are asking whether it's reasonable to learn enough to make a living – during those few months. The first answer is that every student has a different ability to learn and some just have a better aptitude and can understand how options work more quickly than others. So yes, it is possible to produce earnings within that time slot. But not everyone can move that quickly.
To succeed, you must understand what you are trading, and that means taking time to learn options basics. You should have no trouble understanding that options are different from other trading vehicles.
But I must warn you that some traders never get the special characteristics of options and mistakenly believe that they can be traded as if they were stocks. Options are different. Not difficult to understand, but they are different.
If you are brand new to trading, that means there is even more to learn, including basic things such as how to enter an order, how to use your broker's trading platform, the different order types (market, limit, stop etc.). Someone with stock trading experience is already familiar with those items.
In addition to how options work, the trader must possess (or be able to develop) certain personality traits.
Jo, if you are willing to learn how options work, and if you believe you can demonstrate the traits listed below, then you may very well be able to succeed. No guarantees.
I do want to mention one important point. If you expect to make money (income) by buying options and then selling them for profits, let me tell you that this is an almost impossible path. When earning an income stream, the method of choice is to adopt specific option selling strategies – all with limited risk.
Anyone can trade. Anyone can enter the arena and place his/her bets. But to have a chance of making money on a consistent basis, the trader must have:
Discipline The ability to recognize risk How much money is at stake for a given trade The probability of losing money Patience to learn before trading Patience to practice what you have learned, usually in a paper-trading account Ability to control your feelings. Fear leads to panic, which results in terrible decision making Greed has you taking too much risk for too little reward Pride has you refusing to recognize that you made a bad trade and must accept a loss Recognize that a few successful trades does not make you a star trader Understanding that you cannot make money every month Understanding that low probability events do occur – just as statistically predicted Recognize that a 90% chance of winning means there is a very real 10% chance of losing Accept the fact that you cannot make much money when you only have a small sum to invest Knowledge that luck plays a role, and your job is to manage risk when luck is bad
If you are not a member yet, you can join our forum discussions for answers to all your options questions.
Now, to your Question: How much can you make?
If you trade high risk strategies, you have a chance to earn a large sum (10+% per month), but that comes with a very high probability of going broke. High rewards come with high risk.
If you are more conservative (as you are), you may try to earn 'only 2-3%' per month. That's a very good return. Most professional traders cannot earn that much. Brett Steenbarger once told me that the best professional traders earn 'in the low (emphasis on low) double digits' per year. That sounds right to me.
Going by that, earning 1% per month is a realistic target.
However, to give you a better answer, I must ask: How much cash do you have for trading? This is a key question that most beginners ignore. They assume they can earn the same amount of money, no matter how much cash is in the account. This is a huge fallacy. Why? When you begin with a small sum, the risk of ruin, or the probability of going broke, is very large. When you have extra cash, you can withstand a string of small losses and still stay in the game.
Also: When you have a small account, if you have outstanding success and double the account in one year, the total dollars earned is small. It does take money to make money.
Thus, I repeat, how much cash do you have? If you have $10,000 and can do an excellent job and earn 2% every month, that's a grand total of $200/month. That will not take you very far. I assume you would want to earn a minimum of 10 to 20x that amount. To do that you would have to take big gambles. There's a chance that you could have a nice win streak and quadruple your money in a year or so. But the most likely outcome of seeking such huge returns is the loss of all your capital.
Yes Jo, you can do it. If you have the patience. If you take the time to learn and are not rushed into trading. And if you have sufficient capital to give you a realistic chance. If you lack the capital, you can still learn and trade part time. If you grow the account, if you save more cash over the years, if you show the talent and discipline, you may eventually have enough to try trading full time.
I wish I could offer better encouragement, but trading is not a business for everyone. Being a successful investor can be very rewarding over the years. Trading full time is different.
Becoming an Expert
On average, far more traders go broke than become experts. Very few become experts. This question depicts another trader mindset that I believe demonstrates no conception of reality. How long does it take to become an expert? A lifetime.
Experts are few and far between – assuming that by 'expert' you are referring to someone who knows how to make money and then actually makes it and keep it. With that definition, few are experts.
Trading is a game in which you are continually learning. And that's important because markets change over time and if you still do whatever it is that you are an expert at doing, eventually it will no longer work and you will cease being an expert.
It is not necessary to become an expert. You do not have to earn more than the next guy. In my opinion, you can do well (earn decent income) if:
You have the ability to understand how options work. This is not difficult, but some people just don't have the head for it Trade with discipline and overcome emotions. Fear and greed are harmful. It takes a while to overcome those and trade with confidence You take the time to practice. That means using a paper-trading account with fake money. But to gain useful experience, you must believe it is real money and trade accordingly If you don't have to win right now, you need the time/patience to learn. I don't know if a few months are enough. That depends on you
No. I have NEVER used technical indicators. I know that some traders are very skilled in doing just that. But they do not learn overnight, and anyone who tells you it's easy to learn is not telling the truth.
I use no trading software, other than risk management software supplied by my broker.
I suggest getting started by reading or attending some free seminars. If you like what you read and hear, if you understand what you see, then go for it. Plan to spend some time in the education mode. Especially if you set a few months as the time limit. There's no time to waste. I wish you good trading.
Is Your Risk Worth The Reward? 10 Options Trading Myths Debunked Can you double your account every six months? Make 10% Per Week With Weeklys? Why Retail Investors Lose Money In The Stock Market Performance Reporting: The Myths And The Reality Debunking Options Guru Advice
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By Mark Wolfinger
I was taught that one of the assumptions used in this strategy is that for the most part, the market has all ready priced the option correctly for the upcoming news so by allowing for some price movement within your strangle, this is more of a volatility play than a price play.
1) To me they are the same, with the straddle being a subset of the strangle In other words, a straddle is merely a strangle when the strikes and expiration dates are the same.
I prefer the strangle because it allows the trader to choose call and put strike prices independently, rather than being 'forced' to choose the same strike. I prefer to sell OTM calls and puts – and that's not possible with a straddle.
As far as unlimited risk is concerned, that's a decision for each trader. I prefer the smaller reward and increased safety of selling credit spreads (an iron condor position), but that is not relevant to today's post.
2) A clarification. In is not 'volatility' that incurs a large decrease after the news is released. Instead it is the implied volatility of the options. I'm fairly certain that is what you meant to say.
3) Your earnings plays are far riskier than you currently believe them to be. These are not horrible trades, but neither are they as simple as you make them out to be.
4) I must disagree with whomever it was who told you that "the market has priced the option correctly for the upcoming news." The market has made an estimate of how much the stock price is likely to move. Note that this move may be either higher or lower ad that this difference is ignored when the size of the move is estimated.
There is no formal prediction of move size. There is nothing that says the stock will move 6.35 points. What happens is the implied volatility rises as longs as more and more buyers send orders to purchase options. And it makes no difference if they are calls or puts. At some point option prices stabilize (or the market closes for the day) and a 'final' implied volatility can be measured.
From the IV, the 'anticipated move' for the underlying is determined. AsI said, it's not as is everyone agreed on how much the stock will move.
I hope you understand that when the news is released, there is very little chance that the predicted move is the correct move. Many times the move is far less than expected. That's the reason why selling options prior to earnings can be very profitable. The IV collapses because another substantial price change is NOT expected and there is no reason to pay a high IV to buy either calls or puts.
However, if you chose to sell an option that was not very far out of the money (OTM), and if the stock moves far enough, then the IV crush. doesn't do a whole lot of good. Sure you gain as IV plunges, but you can easily incur a substantial loss when the short option has moved significantly into the money.
Also remember that part of the time that stock price gaps by far more than expected. In that scenario, a higher quantity of formerly OTM options are now ITM. Thus, large losses are not only possible, but they are more frequent that you realize. Apparently your trades have worked out well (so far).
Think about this: If those option buyers did not profit often enough to encourage them to pay 'high' prices for the options they buy, they would have stopped buying them long ago. The truth is that these option buyers collect often enough to keep them coming back for more.
5) That means you must be selective in which options you sell into earnings news. This is especially true when you elect to sell naked options. You cannot options on every stock, hoping that any random play will work. This is a high risk/high reward game. It's okay to participate, but please be aware of what you are doing and the risk involved.
By Mark Wolfinger
Do options ever become so expensive that it is no longer worthwhile to pay the high asking price to buy them? We may know that a news announcement is pending, but so do other investors —and they also want to buy options. Translation: Increased demand results in a significant increase in option prices and implied volatility. How can we determine whether a point has been reached such that we have a better opportunity to earn money by switching to negative-gamma (i.e., the opposite of our traditional) strategies?
For this discussion, let’s consider premium-buying strategies are limited to market neutral strategies like buying long straddles and strangles, buying single options, and trading reverse iron condors where you buy the call and put spreads, paying a cash debit to own the position
Similarly, the premium-selling strategies are limited to market neutral strategies like selling straddles, strangles and single options. Also the traditional iron condor (sell both the call and put spreads and collect a cash credit).
It should be intuitively obvious that there has to be some price at which it no longer pays to buy options to own positive positive gamma. [For an extreme example, I hope that you would never pay $8 for a pre-earnings, ATM straddle on a non-volatile, $20 stock.] Thus, as intelligent traders, we are limited and cannot adopt our favorite strategies every time there is an earnings announcement pending. Due diligence is required, and that includes analyzing a substantial amount of historical data so that we can estimate what may happen in the future by looking at what occurred in the past. Such data includes:
Previous post-news price gaps. We want to know the largest and smallest (based on a percentage of the stock price) and the median gaps when this specific stock announced earnings results. We do not need results from the last 20 years because stock markets change over time and more recent history is far more important. I suggest using 3 to 4 years of data (12 to 16 news announcements). Why is this information so important?
The data provides a good estimate of how much you can afford to pay for the options. There are two ways to profit.
First, exit the trade whenever there is a satisfactory profit before news is released.
When implied volatility increases by enough, your position increases in value and it may be attractive to unload the position and lock in the gains prior to the news release.
When the stock makes a big move prior to the news release, the positive-gamma position will be worth far more than you paid for it —and that may be a profit worth taking.
Second, when we do wait for the news release, the profitability of the trade depends on the size of the price gap and the cost of the options.
By looking at past data, we have a reasonable estimate for the size of any future price gap and thus, the value of our option position. Obviously this is just an estimate and the current trade may perform much better or much worse than the average. But, it is that average that dictates just how much we should pay for our option position. If the ATM straddle is worth $6 (on average) immediately after the market opens after the announcement, then we should not be willing to pay as much as $6 to buy the straddle.
The average implied volatility must be considered. If the IV averages 34 for the time slot (i.e., number of days in advance of news), in which we buy the options then we cannot expect to earn a profit when paying 40.
The cost (IV) of buying the pre-news options at a variety of times. It is important to discover a good time to buy the options (i.e., before IV has risen too far in anticipation of the pending news).
The price history for the stock, in the days leading up to the news release: How often did the stock rally/fall enough to generate a good profit without bothering to hold until the earnings news is released? If this never happens for a given stock, then the price that we can pay for a the straddle decreases because one of our profit opportunities is not present.
Results. How would various gamma-buying strategies have performed in the past? This requires examining option-pricing data as well as the stock price.
There is a lot of data that a trader may analyze.
The work produces guidelines for making trades, and we depend on those guidelines to tell us when to enter, and when to avoid, using our methods.
The second question is more difficult to answer because so much depends on the individual trader. For example, some traders will never sell straddles or strangles because risk is too high. Others understand how to manage risk for such trades (most important is choosing proper position size) and would adopt the negative-gamma strategies when the option prices are so high that it is reasonable to anticipate earning a profit by selling them.
Be careful. If you decide that paying $9 for a straddle (or paying a 34 implied volatility) is too high to buy the options that does not suggest that it is okay to sell. Selling requires a decent edge. For example, if your maximum bid for a straddle is $6 (reminder: the average post-news straddle is worth $9), I would not want to consider selling that same straddle unless I could collect $12 (or an IV of at least 40). Those numbers describe my personal guidelines and you must choose your own.
There is a lot of work to do before investing your money into option trades. Fortunately SteadyOptions does the tedious analysis and we can trade their suggestions. There is no guarantee of success. However, it is always good to trade with the probabilities on your side — and that is what you get with your SO membership.
Options Trading Greeks: Gamma For Speed Why You Should Not Ignore Negative Gamma
Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
By Mark Wolfinger
Some investors believe they have a ‘feel’ for the market, or individual stocks and ‘know’ when that stock is going to make a large move. If you are one of them, then don’t open an iron condor position unless you believe the stock is NOT going to make such a move before the options expire. As an alternative you can have an iron condor position with a bullish or bearish bias. You do that by choosing appropriate strike prices for the options spreads you choose.
Many investors (that includes me) cannot predict the future and are willing to own positions that profit when the market holds steady, trades within a range that’s not too wide, or if the market does move significantly in one direction, does so at a slow and steady pace.
It’s generally safer to trade iron condors on indexes because you never have to be concerned with a single stock issuing unexpected news that results in a gap of 20% or more. True that can happen with an index if there is world-shattering news – but it’s a much less likely event.
Most indexes in the U.S. are European style vs. American style. That means they cannot be exercised before expiration – and that’s to your advantage. We’ll discuss the differences between these option ‘styles’ another day.
Most iron condor traders prefer to have positions that expire in the front month (options with the least time remaining before they expire). These options have the most rapid time decay, and when you are a seller of option premium (when you collect cash for your positions as opposed to paying cash), the passage of time is your ally and rapid time decay is a positive attribute for your position.
However, there are negative factors associated with front-month options:
With less time remaining, iron condor positions are worth less than if there were more time remaining. Thus, you collect less cash when you open the position. If the index undergoes a substantial price change, the rate at which money is lost is significantly greater when you have a front-month option position. It’s too early in your education to discuss why this is true in detail, but it’s because they gain or lose value more rapidly than options with longer lifetimes. This is effect of gamma, one of the ‘Greeks’ used to quantify risk when trading options. Because there are so many topics to discuss, I will not be getting to the Greeks for quite awhile. When you sell options that expire in the 2nd or 3rd month, you collect higher cash premiums (good), have positions that lose less when something bad happens (good), but there is more time for something bad to happen (bad). When you have iron condor positions, you don’t want to see something bad (and that’s a big market move). The more time remaining before the options expire, the greater the chance that something bad happens. That’s why traders who sell* iron condors are willing to pay you a higher price for them.
Strike Prices and Premium Collected
Choosing the strike prices for your iron condor position – and deciding how much cash credit you are willing to accept for taking on the risk involved – are irrevocably linked. Thus, I’ll discuss them together.
Assume the call spread and put spread are each 10-points wide.
For example: (RUT is the (Russell 2000 index)
Sell 10 RUT Sep 620 put Buy 10 RUT Sep 610 put Sell 10 RUT Sep 760 call Buy 10 RUT Sep 770 call
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Most of the time that you open an iron condor, you have a neutral opinion, i.e., you have no expectation that the stock is going to move in one direction as opposed to the other. As a result, you tend to choose a call spread and a put spread that are equally out of the money. To put it simply – the call and put you sell will each be approximately the same number of points away from the price of the underlying security. In our example above, If RUT is trading near 690, the 620 put and the 760 call are each 70 points out of the money, and the position is ‘distance neutral.’
There are other methods you can use to have a position that is ‘neutral.’ Instead of equally far out of the money, you may choose to sell spreads that bring in the same amount of cash. This is ‘dollar neutral,’ a method seldom used.
If you understand the term delta (we’ll get to it eventually) you may choose to sell spreads with equal delta. I don’t recommend this method for iron condors, although ‘delta neutral’ trading has a great deal to recommend it under different circumstances.
If you are bullish, you can choose to sell put spreads that bring in more cash, attempting to profit if the stock or index does move higher, per your expectation. If you are bearish, you can choose to sell call spreads that bring in more cash, attempting to profit if the stock or index does move lower, per your expectation.
How far out of the money
Most investors believe that the further out of the money the options they sell, the ‘safer’ their position and the less risk they have. That's one way to look at ‘safety.’
Probability vs. Maximum loss. If you sell the RUT 580/590 put spread instead of the 610/620 put spread, there is a higher probability that the options you sell will expire worthless, allowing you to earn the maximum profit that trading this iron condor allows.
I believe that is intuitively obvious, but for those who don’t see it, consider this (and for the purposes of this discussion, assume you hold this position until the options expire): Most of the time the options expire worthless, but part of the time, RUT moves far enough below 620, resulting in a loss. Part of the time that RUT is below 620 at expiration, it is also below 590. But, the probability that it’s below 590 must be less than the probability that it’s below 620 because part of the time RUT is going to be between 590 and 620. Thus, you lose money less often, when you sell options that are further out of the money. That fits the first definition of ‘safer’.
But, you can also look at it this way. When you sell the 580/590 put spread, you collect less cash than when you sell the 610/620 put spread. This is always true: the more distant the options are from the market price of the underlying stock or index, the less premium you collect when selling single options or option spreads.
This is why it’s so important to find your comfort zone when choosing the options that make up your iron condor.
You can trade options that are very far out of the money. These positions have a very small chance of losing money. You can easily find iron condors with a 90% (or even higher) probability of being winners. However, the cash you collect may be too little to make the trade worthwhile. Some investors are willing to sell iron condors and collect between $0.25 and $0.50 for each spread, netting them $50 to $100 per iron condor. If that makes you comfortable, then it’s okay for you to trade this way. For my taste, the monetary reward is too small. NOTE: Selling a spread for $0.40 translates into $40 cash, and the possibility of losing $960. Remember that the maximum loss is very high, and one giant loss can wipe out years of gains. The maximum loss is $950 per iron condor, when you only collect $50 to initiate the trade.
You can trade options that are far out of the money, but not so far that the premium you collect is too small. You still have a high probability of owning a winning position. You have the potential to earn more money because you collected more cash upfront. The maximum loss is reduced, and some consider this position ‘safer.’ That fits the second definition of safety.
You can sell options that are closer to the money. This reduces your chances of having a comfortable ride through expiration, and increases the chances of losing money. In return for that reduced probability of success, potential profits are significantly higher. You may decide to collect $400 or $500 per iron condor. The maximum loss is much smaller, and again, that fits the second definition of owning a safer position. Your goal should be to find iron condors that places you well within your comfort zone. And if you are unsure of how your comfort zone is defined, use a paper trading account to practice trading iron condors (or any other strategy). I know that real money is not at risk, but if take the positions seriously, you can determine which iron condors leave you a bit uneasy and which ‘feel’ ok. Advice: Don’t make the decisions about comfort based on which trades are profitable. Base the decision on which iron condors make you nervous about potential losses both when you open the position and as the risk changes over time.
It’s easy to randomly open positions and hope they work. But it’s better to open positions that fall within your comfort zone.
Here’s a statement I am going to make repeatedly when giving stock option advice: There is no ‘right’ choice. As an investor, you want to hold positions that are comfortable for you. The best way to discover your comfort zone is to trade. But, please use a practice account and do not use real money until you truly understand how iron condors (or any other strategy) work. Some traders always trade the near-term (front-month) options, while others (myself included) prefer options that expire in two, three, or even four months.
Another comparison is Iron Condor Vs. Iron Butterfly
Trade Iron Condors Like Never Before Why Iron Condors are NOT an ATM machine Why You Should Not Ignore Negative Gamma Can you double your account every six months? Can you really make 10% per month with Iron Condors? Should You Leg Into Iron Condor? Exiting An Iron Condor Trade Iron Condor Adjustments: How And When Iron Condor Adjustment: Can I "Roll" It Forever? Is Your Iron Condor Really Protected? Trade Size: Taming The 800-Pound Gorilla
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Iron Condor Description
Iron Condor is a vega negative gamma negative trade. Choosing the strike prices for your iron condor position – and deciding how much cash credit you are willing to accept for taking on the risk involved – are irrevocably linked. If your strike has lower deltas, you will get less credit, but also higher probability. As we know, Risk/reward and Probability of Success have reverse relationship.
Buy one out-of-the-money put with a strike price below the current price.
Sell one out-of-the-money put with a strike price closer to the current price.
Sell one out-of-the-money call having a strike price above the current price.
Buy one out-of-the-money call with a strike price further above the current price.
Lets take a look at typical Iron Condor trade using SPX and 15 deltas for the short options.
As we can see, we are risking ~$750 to make ~$250 (around 33% gain), but we have a fairly high probability of success (~78%). We can select tighter strikes, for higher credit and better risk/reward, but we will be sacrificing the probability of success.
Iron Butterfly Description
Iron Butterfly spread is basically a subset of an Iron Condor strategy using the same strike for the short options.
Buy one out-of-the-money put with a strike price below the current price.
Sell one at-the-money put.
Sell one at-the-money call.
Buy one out-of-the-money call with a strike price above the current price.
Lets take a look at Iron Butterfly trade using SPX:
As we can see, we are risking ~$880 to make ~$4,120 (around 455% gain), but we have a fairly low probability of success (~30%). We can select further OTM long strikes, for lower credit and higher probability of success. But generally speaking, Iron Butterfly will usually have a better risk/reward but lower probability of success than Iron Butterfly.
Which one is better?
As you can see, there are tradeoffs to each strategy. Both strategies benefit from range bound markets and decrease in Implied Volatility. The Iron Butterfly has more narrow structure than the Iron Condor, and has a better risk-to-reward, but also lower probability of success. If the underlying stays close to the sold strike, the iron Butterfly trade will produce much higher returns.
Both strategies require that the underlying price stay inside of a range for the trade to be profitable. The Iron Condor gives you more room, but the profit potential is usually much less.
Generally speaking, Iron Condor is a High(er) Probability trade and Iron Butterfly is a Low(er) Probability trade. However, those probabilities refer to holding both trades till expiration. In reality, we rarely hold them till expiration. We usually set realistic profit targets and exit at least 2-3 weeks before expiration, to reduce the negative gamma risk.
The bottom line is that the strategies are pretty similar because they profit from the same conditions. The major difference is the maximum profit zone, for a condor is much wider than that for a butterfly, although the tradeoff is a lower profit potential.
Trading An Iron Condor: The Basics Butterfly Spread Strategy - The Basics 4 Low Risk Butterfly Trades For Any Market Environment Using Directional Butterfly Spread Options Trading Greeks: Gamma For Speed Options Trading Greeks: Vega For Volatility Why You Should Not Ignore Negative Gamma
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