Fortified With Iron: Making Money in a Sideways Market

The following article is from the summer 2009 issue of Bernie Schaeffer's SENTIMENT magazine, which is designed specifically for those interested in trading options. Every issue of SENTIMENT includes educational pieces for newcomers to options trading, as well as advanced strategy stories to help experienced traders build their portfolios. Please click here if you would like to receive your own copy of the next quarterly issue of SENTIMENT.

One of the beautiful things about trading options is the ability to construct an abundance of different strategies to take advantage of a multitude of market conditions. For example, if you're very bullish, you could simply buy calls. But if market volatility is high and option premiums are too rich for long purchases, you could sell puts that profit from rapid time decay. And if you fear a market collapse will sink your bullish stock, you could always hedge that short put with a long put, further out-of-the-money, to create a short put vertical spread.

Short verticals are a great way to trade up, down, and sideways markets. But once you've grasped the basic concepts of verticals, in many situations, with just one extra step, you can get a lot more bang for your buck with something even better—iron butterflies and condors. Iron spreads such as these are ideal for stocks that are trading in a short-term range, typically during periods in which stocks are taking a breather and soaking up the gains from a large run-up in price, or basing after a sell-off. Since they're short strategies, they benefit from the stock not really doing anything. And if the stock is not expected to do much other than trade in a range, how about placing two verticals for less than the price of one? This is exactly what we're doing with an iron butterfly or condor.

A Quick Word About Time

There aren't many guarantees that traders can count on, but one absolute is that time will pass. This works to the benefit of the option seller, because with each passing day, time decay erodes an option's extrinsic (time) value, which is any of the premium that is not considered "in-the-money" (its intrinsic value). Though there are several other inputs that make up time value, what's important to understand is that all things being equal, the option you buy today will be cheaper tomorrow. Short strategies that benefit from this phenomenon, such as the iron butterfly and condor, are said to have positive time decay. That basically means that time passing produces a profit for the option seller and a loss for the buyer.

Getting Your Iron Fix

Despite their exotic-sounding names, the iron butterfly and condor are simply combinations of two short vertical spreads—one short put vertical and one short call vertical— stacked on top of one another. To recap, a short vertical is a defined-risk strategy composed of an equal number of short options at one strike, and cheaper, long options at a different strike with the same expiration, as a hedge (the strikes are usually adjacent to one another). The result is a net credit to the trader's account at the onset of the trade, and it's profitable when the entire spread can be bought back for a debit that is smaller than the initial credit taken.

If the concept of short spread trading is foreign to you, what's important to understand is that eventually, all time premium decays to zero—at expiration. Options with greater time value will decay faster than those with a lesser time value of the same maturity, such as those farther out-of-the money. This is the case with the short verticals within the iron spreads. The short option that you sell with greater time premium decays more quickly than the time premium in the cheaper, long option. The result is that as time marches on, the spread at some point becomes cheaper, thus rendering a profit since you are a net seller of premium. It's essentially turning the concept of "buy low, sell high" upside down by selling high first, then buying back low later. The compounded verticals within the iron spreads give these strategies a double whammy.

The difference between the iron butterfly and condor has to do with the positioning of the short strikes. The iron butterfly shares the same short strikes, while the short strikes of the iron condor are different (usually adjacent). While there are several reasons you may wish to choose one over the other, something to consider is that while the iron butterfly has a better reward-to-risk ratio, the iron condor has a higher probability of success due to the fact that it will profit over a greater range of stock prices. It's a trade-off of probability versus profit. You decide.

Creating the Iron Spread

Let's look at constructing both an iron butterfly and condor trade around the hypothetical example XYZ at $50.

The Iron Butterfly: Suppose the stock has just come off of a deep sell-off in the last two months, and after some wild swings, has been forming a base, trading in a range between $47 and $53 for the better part of two weeks on declining volume.

With XYZ at $50, an iron butterfly can be constructed by simultaneously shorting the 45/50 put vertical for $2 and the 50/55 call vertical for $1.75 (see Figure 1), entered as a single spread for a net credit of $3.75. Since there is $5 between strikes for each of the verticals, and the stock can't finish in two places at once, your risk is only the distance between the strikes of one of the verticals minus the total credit received for both, or $1.25 ($5 – $3.75).

Essentially, the two verticals share the same strike because you sell the "body" of the butterfly at the 50 strike (short 50 put/ short 50 call) and buy the "wings" at the two ends (buy 45 put/ buy 55 call). When the two verticals are stacked on top of one another, your risk curve of the 45/50/55 iron butterfly looks like Figure 1.

As long as the stock finishes somewhere between the breakeven marks of $46.25 and $53.75 at expiration, you make a profit, with the maximum profit realized if the stock is at $50. Essentially, this is a $7.50 wide "airstrip" for XYZ (which is trading in a $3–$4 range) to "land" on.

The Iron Condor: Suppose XYZ is trading in a bit wider range than in the prior example, rather than hovering around $50 in a tight range. Volatility remains relatively high, and while you feel uncertain about the stock finishing right about $50, your analysis shows a high probability of the stock staying within the range of $50 to $55.

With the stock at $50, you can place a 45/50/55/60 iron condor at both ends by shorting the 45/50 put vertical for $2 and shorting the 55/60 call vertical for $0.90 (see Figure 2). The distance between the two short verticals here is $5, and while the $2.10 risk in this trade is greater than the $1.25 risk of the iron butterfly, the range for which the stock will profit is $10.80 ($3.30 more than the iron butterfly). What's more, the maximum profit is achievable between $50 and $55, versus a maximum profit in the iron butterfly at only the exact price of $50.

Setting Up the Trade

Since it's far easier to assess a stock's range in the short term, it's a good idea to try to place your iron spreads with two to eight weeks to expiration. Not only is there a greater chance the stock will finish where you want it to, but you'll also be taking advantage of the greatest amount of time decay (which occurs in the final weeks before expiration).

The question you may also be asking is, how much credit should you expect to take in? This has more to do with reward-to-risk in the trade than the actual dollars received. Depending on the stock you choose, there are many different strike combinations. You could be working with strikes as little as $1 apart, as in the case of QQQQ or SPY, or as far apart as $10, as with GOOG. Assuming volatility is working in your favor, typically, you'll want to look for trades that have at least a 1-to-1 reward to risk on your iron condors, and an even higher probability for the iron butterfly.

What this means is that you should be able to make at least $1 by risking $1. You can assess this by simply dividing the distance between the strikes of just one of the verticals by the total credit taken in for both verticals. For example, the iron butterfly we created earlier (Figure 1) would have a 3-to-1 reward-to-risk ratio ($3.75 credit, divided by $1.25 risk).

A Couple of Final Thoughts

Keep in mind that while we have been talking about trading iron spreads on stocks in a range, by no means is that "range" limited to a sideways pattern. There are plenty of opportunities when you may want to use iron spreads as directional trades on stocks that are trending up or down.

But no matter what trend the underlying has taken on, the point is that if you're able to predict with high probability where it will likely end up at expiration, you can use iron butterflies and condors to create very efficient trades with extremely high reward-to-risk ratios. In fact, this golden combination of positive time decay, limited risk and the potential for a reward to risk ratio greater than 1 to 1 is what makes the iron spread strategy so unique.