Last week’s article began a discussion of the basic decisions we traders make about complex options positions such as butterflies and iron condors. That article can be found at this link. As mentioned last week, those considering such complex positions have some basic decisions to make:

Which strategy?
Which underlying?
Which strikes?
What size and/or how much money to allocate to the trade?
How many days to expiration to begin?
Adjust or take off when it goes wrong?

Last week's article showed the basic setup for a butterfly. This week, let's look at a basic setup for an iron condor. Taken together, the two articles will provide the context to answer the "which strategy" question when deciding between these two theta-positive, vega-negative strategies. As I mentioned last week, my history with the theta-positive, vega-positive calendar, also a valid income strategy, is spotty. I will not be discussing that strategy.

As with the butterfly, we soon find that there is no one right or wrong way to set up an iron condor. Iron condors are typically created from calls and puts, with closer in calls and puts sold, and further-out calls and puts bought as hedges. The following setup mimics the one I used to employ on the RUT, OEX, SPX and sometimes other indices. I sometimes even employed it on equities, depending on liquidity issues and the market conditions in certain years. However, since trades using cash-settled index options have in the past enjoyed some tax advantages, I tend to prefer index trades.

Since last week's article addressed the RUT, we'll use the RUT for this article, too. Since this article is being roughed out at a different date, January 16, 2013, RUT levels and pricing, as well as days to expiration will be different. Because an additional week had passed before this article was roughed out, and the February monthly cycle utilized in the prior article would have only 30 days to expiration at that point, these iron condors will be set up using the March cycle, with 58 days to expiration at the time the article was roughed out and the charts snapped.

Out-of-the-money options such as those that make up the iron condor decay differently than the sold at-the-money options often employed in the butterfly's construction. Out-of-the-money options often see decay accelerate from 60 days to 30 days. That is the reason I preferred to open my iron condor trades about 55-65 days from expiration. So that this position's margin and loss parameters are roughly equivalent to those from last week's butterfly trades, this one is set up as a three-contract iron condor.

RUT March High-Probability Iron Condor Positions:

Strategy Summary:

Expiration Graph:

As we can estimate from this graph and see from the Strategy Summary provided by freeware OptionsOracle, the maximum loss with this strategy is $2,651.50. This is not so different than the $2,208.00 and $2,175.00 figures that we saw for maximum losses in the two butterfly examples from last week's article. I wanted to set up the trades so that we are comparing apples to apples as far as margin or buying-power effect is concerned.

However, many butterflies require the trader to pay a debit, while iron condor traders take in a credit. What also is different is the maximum profit potential seen in this iron condor. That's only $348.50. Scanning across the expiration graph, it's obvious that's all that it is possible to make on this trade. That is much less than the profit available on the butterfly versions. What's the tradeoff, then? Why would anyone trade an iron condor?

The answer harks back to one of those initial questions: Will you adjust or just take off a non-performing trade? As this article was roughed out on January 16, 2013, a one-standard deviation move for the RUT from initiation of the trade through to the March expiration would take the RUT from about 836.19 to 928.43, a rather wide range, and a one-and-a-half standard deviation move would take it from about 790.88 to 974.54. With this particular iron condor, as constructed above, the RUT could move more than 1.5 standard deviations to the downside and more than 1 to the upside without getting outside the expiration breakevens. (Note: that does not mean that you could comfortably let the RUT do that at all times during the trade without suffering large unrealized losses, of course.)

However, the butterfly's construction does not allow the underlying to move so far and still stay within the expiration breakeven. On January 10, when the theoretical 930/880/830 one-contract butterfly was set up, both expiration breakevens were inside a one-standard deviation move for the RUT, with a one-standard deviation move from trade initiation to February expiration at about 851.85 to 907.65.

The RUT could not move even one standard deviation to either side without being outside the expiration breakevens on the butterfly. That means, by definition, the butterfly is likely going to need more adjustments than the iron condor, and the iron condor will need fewer than the butterfly. That is the theory: it does not always work out the same way in practice, and we will see in a later article that adjustments can be more difficult and pricier for the iron condor.

The iron condor seen above was established by selling the first call strike with a delta under 10 or 0.10 if your quote system quotes them that way and then buying a call 10 points further out, also selling a put at the first strike with a delta above, since we're talking negative numbers, -9 or -0.09, and then buying a long put 10 points further out. This is often termed a "high probability" iron condor because there's a high probability that the RUT will be inside the expiration breakevens at expiration. As iron condor traders learn sooner or later, there is not quite so high a probability that it will stay within those breakevens all through the trade.

This is just one type of iron condor. Some traders prefer a "low probability" iron condor, one in which the sold strikes are brought in closer to the money. What would you expect from this? You would expect more credit taken in for the same width spread. You'd expect, though, a greater chance that the RUT would violate the expiration breakevens at expiration. In fact, you'd expect the iron condor to become more butterfly-like. Take this to the extreme by smushing together the sold put and call at the same strike, and you have the iron butterfly. Although I would normally make the wings on a RUT butterfly 50 points wide in my own trading, I have changed that in this case. I've made the wings 40 points so that the margin stays under $3,000, to make the trade more comparable to the others we've seen.

Iron Butterfly Component Positions:

Expiration Graph:

The RUT was at 882.31 at the time this was set up, so not exactly at the 800 central strikes. However, you can see that sliding the sold put and sold call to the same strike on an iron condor creates a butterfly shape, the iron butterfly, a shape with more potential credit but closer-in breakevens than either the high- or low-probability versions of iron condors.

It should be clear by now that iron condors and butterflies share some characteristics and have some differences that traders should consider. All the trades in these last two articles have been set up to have similar, if not exactly equal, maximum losses, between $2,100-$3,000. Some take in credits, as do iron butterflies and iron condors, and some require a debit. Some have closer-in expiration breakevens that mean the trades may need more frequent adjustments or may not be suitable for those who don't ever want to adjust. We'll look at other considerations in the next article.