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butterfly vs. condor
What is the difference between an iron butterfly and a condor?
Before examining the discrepancies between these strategies along with their advantages and disadvantages, let me note that option terminology differs depending on where you are. The two US financial hubs, New York and Chicago, have their own language when it comes to option strategies. A broker on the Cme floor may have a slightly different view on what exactly a condor is relative to someone standing in a Nymex option trading pit. That said, you should be familiar with the details of the strategies as well as the name. Knowledge could avoid costly communication errors between yourself and your broker.
In literal terms, both butterflies and condors have wings, and this is likely where the option terms stem from. In reference to option strategies, these approaches involve limited risk and profit potential. However, the similarities end there. An iron butterfly trader and a condor trader will have vastly different goals in the market.
The most prominent difference in strategy is the cash flow that occurs upon entry and exit. A condor trader is most interested in collecting premium in hopes that the market trades sideways, while an iron butterfly trader is willing to pay premium in anticipation of the market moving in the desired direction.
Whether a trader receives or pays a premium for the spread is based on the value of each of the option legs involved. If it requires more premium to be paid for the long options than is collected for the short, the trader is buying the spread. Similarly, if the trader collects more for the short options than is paid for the long options, the trader is selling the spread. That said, conventional wisdom suggests that butterflies should be executed during times of low volatility and low option premium, and condors should be executed in the opposite scenario.
An iron butterfly is a four-legged spread involving three different strike prices in the same commodity and month. If you are familiar with options, you may realize that this strategy is simply the combination of a bull call spread and a bear call spread. Specifically, a call iron butterfly trader may buy an at-the-money call option, sell two out-of-the-money calls, and then purchase an equidistant call option to limit the risk of the spread. An iron butterfly can be sold but is typically used as a long option strategy, whereas the cost of the long calls outweighs the premium collected for the short calls.
The result is a limited risk option spread in which the trade pays off something to the trader at expiration as long as the price of the corresponding futures market is trading between the strike prices of each long call option. The profit potential of an iron butterfly is limited to the distance between the strike prices of the long and short calls minus the premium paid. The maximum profit occurs if the futures market is trading at the strike price of the short calls.
A condor strategy includes a credit spread on both sides of the futures market; for those of you familiar with options, you may recognize this as simultaneously holding a bull put spread and a bear call spread. A condor trader is hoping that both spreads expire worthless. If this is the case, he gets to keep the original premium collected upon entering the trade.
An example of a condor would be to buy a March S&P 550 put and sell a 600 put while also buying a March S&P 1150 call and selling an 1100 call. Hypothetically, such a trade may collect about $12.50 in premium or $3,125 for the seller. This is calculated by multiplying the premium collected by the S&P futures point value of $250.
Like an iron butterfly, the condor strategy entails limited risk and limited profit potential. The most money that a condor trader can make is the original net credit of $3,125 minus the commissions and fees paid. With four legs per spread, the transaction costs can add up, so they shouldn’t be overlooked. The maximum profit occurs if both sides of the condor expire worthless. Keep in mind that it is only possible to lose on one side of the spread at expiration, not both.
The benefit of a condor over a simple short option strategy is the peace of mind that comes with knowing the worst-case scenario. The world could come to an end, yet the losses incurred in a condor strategy will be limited to the difference between the strike prices of the long and short options minus the net credit received upon entry. In this example, the total risk would be 37.50 or $9,375 ((50 - 12.50) x $250). While this is a steep figure, at least it is known.
Options can be a versatile trading tool in which traders are able to adjust their strategy based on desired risk and reward prospects. In addition, a trader can speculate on a large market move or a stagnant market through the use of condors and butterflies. Perhaps volatile market conditions warrant the use of limited risk option spreads such as these.