As a good vegan and a softie at heart, I would never chop an actual butterfly in half. However, what happens if we chop a butterfly constructed of options in half and separate the halves? Let's see, utilizing the IWM, the iShares Russell 2000 Index, as our vehicle for constructing the butterfly.

For newbies to complex options positions, the butterfly is a complex trade that is composed when the trader sells two options at the same strike (both calls, both puts or one a call and one a put) to form the body of the butterfly. In the same trade, two long options (both calls, both puts or one a call and one a put) are bought an equal distance either side of the strikes that form the body of the butterfly. The long options form the wings of the butterfly in this traditional setup. The setup is flexible, so that one wing might be shortened with respect to the other. For example, I might set up a one-contract RUT butterfly by selling two 1160 puts, buying one 1110 put (50 points away from the central strike) and one 1190 put (30 points away from the central strike). This non-traditional form will likely require margining on both sides, however, while the traditional form with equal wing sizes requires margining on only one side. If I wanted a five-contract butterfly, I would have sold 10 1160 puts, bought 5 1110's and 5 1190's.

Let's utilize a traditional all-call butterfly constructed of IWM options to start our discussion about splitting flies.

Hypothetical At-the-Money (ATM) Butterfly Trade, Constructed at 11:55 AM on Monday 8/11, with the IWM at 113.74, Graph by OptionNet Explorer:

This is a five-contract ATM butterfly constructed by selling 10 SEP 114 calls, and then hedging with 5 SEP 109 calls and 5 SEP 119 calls. Now, let's split the butterfly in half and separate the two halves. This is accomplished by moving -5 114 SEP/+5 119 call verticals up to -5 SEP 116 calls/+5 SEP 121 calls and by moving -5 SEP 114 calls/+5 SEP 109 calls down to -5 SEP 112 calls/+5 SEP 107 calls.

Butterfly Trade Split in Half and the Halves Moved away from Each Other, Graph by OptionNet Explorer:

Notice the flattened top rather than the typical tent shape of the butterfly. This looks like a condor, doesn't it? A condor is composed by selling an above-the-money option and buying a further-out above-the-money option as a hedge and also selling a below-the-money option and buying a further-out below-the-money option as a hedge.

If the original ATM butterfly had been an iron butterfly, it might have been constructed by selling 5 ATM calls and 5 ATM puts and buying 5 OTM calls and 5 OTM puts to hedge. Separating the two halves and pulling them apart would have created an iron condor. This exercise helps show us the relationship between butterflies and condors and removes some of the mystique that iron condor traders might assign to butterflies or butterfly traders might assign to iron condors.

A trader is unlikely to separate the halves and move both halves apart, but there are circumstances in which the trader might move one half. Let's look at what I mean, using an iron butterfly as an example. First, let's look at the original hypothetical iron butterfly, to see how it's constructed.

Hypothetical Iron Butterfly, Graph by OptionNet Explorer:

This graph can be compared to the first one, the original all-call butterfly. Whether constructed of all calls, as was the butterfly in the first graph, or both calls and puts, the butterflies are almost identical. Delta is a little more negative with the iron butterfly.

Because of the similarities, one first conclusion we can reach is that the differences in butterflies are not that big, no matter whether they're constructed of all calls, all puts or both calls and puts. Some traders make a habit of entering call butterflies when they're placing the center of the butterfly above the underlying's current price, all puts when they're placing the center of the butterfly below the underlying's current price, and as an iron butterfly when they're placing the butterfly at or very near the underlying's current price. That has more to do with trader preferences and beliefs about the ease of fills when placing or adjusting the trade than anything else.

Let's move only one side of the butterfly, the call side.

Splitting the Fly in Half and Rolling the Call Credit Spread Higher, Graph by Option Net Explorer:

The original -5 SEP 114 Call/+5 SEP 119 Call spreads have been rolled higher to -5 116 Call/+5 SEP 121 Call spreads. If your platform allows the procedure and markets are quiet with enough option volume, this can be done with a single trade order, condor-rolling the credit spread higher. (See my August 8 Options 101 article, "Will Your Brokerage Let You Do This?" in the archives for an explanation.)

What has happened as a result of splitting the butterfly and rolling those spreads higher? The expiration chart takes on the typical iron condor look. Expiration breakevens, both upper and lower, are shifted to the right. Delta is much less negative. The maximum gain is now under \$1,500 when it was above \$1,500, but there's a greater distance when the current maximum gain can be obtained. In actuality, few of us are going to hang onto a butterfly or iron condor into expiration and obtain the maximum possible profit anyway. The main benefit of this move would be to help the trade weather a push to the upside. It's an adjustment that might be utilized by some butterfly traders. In fact, it is one that I and many of my butterfly-trading friends have used on occasion.

Let's imagine taking the opposite tack. What happens when you scrunch an iron condor's sold strikes together? You get an iron butterfly. What's the point of all this splitting flies or scrunching together of condors in this article? We traders can get too tied up in whether we're butterfly or condor traders. Especially when we're beginning to trade these strategies, we might freak out a little if we simulate a possible adjustment and the expiration graph morphs from butterfly to condor or from iron condor to butterfly, for example. In truth, a butterfly is just a scrunched-together condor, or a condor is a split-apart butterfly. Both are vehicles that involve selling options and then hedging the possible loss by buying further out options on either side. Both are positive theta positions, meaning that they typically benefit by the passage of time as time-related decay occurs. However, both are also negative-vega trades, and they can be hurt by a rise in implied volatility. Each type can be bought for a debit or sold as iron butterflies or condors, for a net credit. And that's just a quick summary of traditional butterflies or condors. Speculative ones with different wing sizes can be constructed, too, for purposes too numerous to cover in a single article.

Of course differences exist, too, and those differences can absolutely impact the trade. Because the central strikes tend to be sold closer to the money in butterflies, those butterflies tend to offer more possible gains. Although we may not typically hold butterflies into expiration and capture that greater possible gain, another benefit comes about because of that greater possible gain. They can absorb more realized losses as they are adjusted.

That benefit to butterflies is offset by the knowledge that unless the trader encounters a particularly smooth month, butterflies are going to have to be adjusted more frequently. The expiration breakevens are typically under a standard deviation move for the period the trade will be in effect, so it's likely that the underlying is going to move outside the expiration breakevens. An iron condor can often be constructed so that, on a statistical basis, it's less likely that the expiration breakeven will be violated before expiration. That benefit is offset by the knowledge that it's going to hurt a lot more if that violation of expiration breakevens happens with an iron condor. It's also harder to adjust condors and maintain the possibility of profit at expiration. For these reasons, condors are often adjusted well before the underlying touches an expiration breakeven.

The take-away point? Understand that if you're going to be adjusting either your butterflies or condors, iron or not, you're likely going to morph those trades into the other type at some time or another. That's not a cause for heart-pounding anxiety, but it's probably a good reason for condor traders to be familiar with butterflies, and vice versa.

Happy learning.

Linda Piazza