Through the Couch Potato newsletter, some inveterate iron condor traders have been newly introduced to iron butterflies. While the two trades have some obvious differences, they're close enough in makeup to be considered kissing cousins.
Their family similarities show up right away. On many brokerages and perhaps on most, the same order form is set up. As far as the order form is concerned, you're selling an iron condor for both iron butterflies and iron condors. The two have the same surname, if you will. You're collecting a credit for both the iron condor and the iron butterfly.
Typical RUT High-Probability Iron Condor, 56 Days to Expiration:
Typical ATM RUT Iron Butterfly at 56 DTE:
If both trades are officially entered by selling iron condors, the differences quickly become apparent when viewing the shapes of their expiration graphs and the locations of their expiration breakevens. Because the graphs had to be narrowed for publication, it's not possible to view the credits received for the two trades, but they were $1.27 for the iron condor and $32.25 for the iron butterfly. That's quite a difference. Comparing expiration breakevens and credit received for each makes their essential differences apparent, especially when the deltas of the two trades are also compared. The iron condor trader receives less credit for the risk, but the RUT's price can range much further without damage to the trade. That benefit to the iron condor might have come in useful over the last week when the RUT ranged from 924.21 up toward 960. The delta is much flatter on the iron condor trade.
The iron butterfly trader receives much more credit so that adjustments are easier to make while preserving some possibility of profit. However, the RUT's price can't range nearly as far before adjustments are required.
But the two trades remain kissing cousins. The similarities in the two trades become more apparent when the iron butterfly is adjusted by rolling out one of the credit spreads. The following graph simulates hypothetical conditions when a week has passed from the initial setup shown, the RUT has moved up to almost 956, and an adjustment has been made. That's very nearly what happened: the RUT moved up a bit more, almost to 960. That adjustment is condor-rolling the 940/990 call spread up to the 960/1010 spread.
Iron Butterfly after Simulated Adjustment under Hypothetical Conditions:
This condor roll adjustment has transformed the typical butterfly shape into more of a typical iron condor shape with a flat top, albeit a narrower iron condor than the typical ones once employed in the Couch Potato space. If, in our hypothetical situation, the RUT continued higher and another adjustment was made, that adjustment might be to roll the put portion up to the 960/910 level, recreating the typical butterfly tent shape.
While these basic similarities and differences are easy to spot and learn, another difference in the wide iron condor and the iron butterfly might not be so easy to spot. That difference lies in the variation in the ways far out-of-the-money and at-the-money options decay.
I'll let Jim Bittman, CBOE instructor and author of Trading Options as a Professional explain. He warns that out-of-the-money options decay differently than at-the-money options. He concludes that 5-10 percent out-of-the-money options decay more in the period from 60 days to expiration to 30 days to expiration than they do in the period from 30 days all the way through to expiration. All those graphs we see that show us how decay accelerates under 30 days are referencing at-the-money options. Iron butterfly trader often sell the options that comprise the body of the butterflies at or near the money.
This difference in decay rates "should give pause to traders and investors who employ strategies that sell options consistently," he states, "especially if the sold options are 5 or 10 percent out of the money" (67). The more out of the money they are, the more quickly they decay in that 60-30 day out period. Of course, those wide iron condors with options sold way out of the money are just the type of trade he referenced. For those traders, he suggests "that under certain circumstances, selling a two-month option, covering it one month before expiration," and then moving on to the next trade might be a better tactic than selling an iron condor around 30 days to expiration.
Another difference that isn't quite so apparent when viewing the initial setup, then, is this factor of decay. Traders want the value of the sold options to decay in both these trades. In some circumstances (not when you expect a sudden ramping up of implied volatilities), iron condor traders might want to start earlier than butterfly traders, while butterfly traders have more flexibility about starting closer to expiration.