The last two Options 101 articles have discussed the basic setups for two often-employed complex options trades, the butterfly and the iron condor. Those articles can be viewed here and here.

The various trade setups were intended as part of a discussion of the decisions options traders make as they evaluate various strategies. Some of those decisions are as follows:

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?

The various hypothetical iron condor and butterfly setups were constructed so that the margin or buying-power effect was between about $2,100-2,900. That means that we're comparing apples to apples when comparing and contrasting the two strategies.

Comparing the two strategies, we find that both are theta-positive and vega-negative. As long as the prices of the underlying are inside the expiration breakevens, the trades' profit-and-loss line will benefit from the passage of time, the theta-positive component.

At least in the beginning of these trades, the profit-and-loss line will theoretically be hurt by a rise in implied volatilities. The relationship of implied volatilities can be a bit more complex than can be addressed in a single article. These strategies are composed of options at different strikes, and those different strikes will react differently to changing conditions. Implied volatilities might rise or sink differently in response to a change in conditions, changing what is known as the skew or the shape of the implied volatilities curve.

However, the focus for this article should remain on generalities for these articles on the basics. Generally, these two trades or strategies react in the same direction of gains or losses with response to those the passage of time and changes in implied volatilities, at least in the beginning of the trade. The week of option expiration, all this can shift, which is the reason that I don't tend to carry these trades into expiration week.

Because these two trades are generally hurt by a rise in implied volatilities, many traders set them up so that the delta is negative. A negative delta means that the trade benefits from a price pullback. When implied volatilities rise, that's often due to a pullback in price, although not always, so that the harm done by the rise in implied volatilities is at least partially offset by the beneficial effect of a drop in prices, at least over a modest distance.

Therefore, if you're deciding between these two trades, their response to the passage of time or the rise or fall of implied volatilities will likely not be your deciding point. Although the degree to which they react to these two inputs will differ, the direction is similar. In addition, both trades can be employed with either the major indices or with the equities that have highly liquid options.

However, if you're a connoisseur of the obscure little company with a low average trading volume, I applaud your in-depth knowledge of the company, but I wouldn't suggest that you employ either of these trades with that underlying. That's particularly true with the iron condor with its far out-of-the-money strikes. You may not even have the necessary strikes available to compose the strategy.

SCSS Option Chain 1/26/13:

This is a snapshot of all available March calls for SCSS on January 26. SCSS traded near $23 as this snapshot was taken.

Note how quickly the bids go to zero on the strikes above the $22.50 strike? There's still a $0.05 bid at 30, but a volume/open interest view would have shown you that volume drops off quickly either direction away from $22.50. The 20 call has a volume of only 3, for example, and the 35 call, only 6.

If you wanted to roll or take other actions with the OTM options that comprise a high-probability iron condor, you'd practically have to hunt up a floor trader and haggle with that trader over the price. This does not look like a good candidate for an iron condor, at least, and I likely wouldn't be trading it with a butterfly, either. I'm used to far more strikes available with far higher volume at those strikes. I think any trader employing an iron condor or butterfly needs to know something about the underlying being used, but knowing the underlying doesn't imply that it's a good candidate for these strategies.

One of the main decisions to be made when deciding between these two strategies concerns whether you want to and are willing to adjust, and how frequently you're willing to do so. Below you'll find an expiration chart for a theoretical OEX iron butterfly, split strike because the OEX was near 677 at the time the trade was set up, between the 675 and 680 strikes. Wings are equal sizes at 30 points. You'll also find the expiration chart for a high-probability iron condor. Both strategies are constructed of options in the MAR cycle. The butterfly has a maximum loss of $2930 at expiration, and the iron condor has a maximum loss of $2700 plus commissions, so they're similar in their margin requirement or buying-power effects.

Let's look at what happens if the OEX had jumped up to 690 by Wednesday, January 30. We know this didn't happen, but the markets seemed to be in a runaway mode when this article was first roughed out, and the trader looking at charts would not have had a crystal ball. When experimenting with the effect of a rabid rally on a strategy, I normally would have rolled implied volatilities down, too. In this case, the volatility measures have been so low, I thought it unlikely they would sink too much further.

OEX Butterfly, Theoretically on January 30 at 690.00

OEX Iron Condor, Same Conditions:

If you scan to the bottom line for the locked-in "690.00" price point, you see that the butterfly's loss grows more rapidly than the iron condor's, at least over this price range. At initiation, it already had a more negative delta, but at a -18 level versus the iron condor's -12, that alone doesn't account for the difference in behavior.

Others might qualify the two behaviors differently, but in my mind, the iron condor doesn't get into trouble as quickly as the butterfly does. This is true to the information in the prior articles about the locations of the expiration breakevens in comparison to standard deviations. However, when the iron condor begins to get into trouble, it gets into bad trouble, very quickly. Statistics are not on the side of the butterfly trader who is disinclined to adjust, and experience is not on the side of the iron condor trader who is subject to "deer in the headlights" syndrome.

Make no mistake. The iron condor is likely going to need adjustments, too, or else a plan to take it off once unrealized losses reach a certain level. Don't ignore unrealized losses with the iron condor! The butterfly, however, is going to need those adjustments more often and more quickly.

What's the tradeoff, since there always is a tradeoff? Adjustments tend to be easier to make with the butterfly. There's more profit to work with, too. Making adjustments means you're likely going to incur some slippage, and there's just not much profit to work with in those iron condors. The incurred slippage hurts more. In the next article, we'll look at how adjustments can impact the iron condor.