Aug 15 2008
Butterflies, Bulls and Bears
I recently read an interesting article comparing the various complex stock options spreads available to those of the stock option persuasion. I can’t vouch for the correctness of the table but it does provide some food for thought.
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Condor
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Iron Condor
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Butterfly
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Iron Butterfly
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Debit/Credit
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Debit
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Credit
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Debit
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Credit
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Max Profit
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Low
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High
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Higher
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Highest
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Max Loss
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Highest
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Higher
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High
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Low
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Cost
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High
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Nil
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Low
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Nil
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Profit Range
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Wide
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Widest
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Narrow
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Wider
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Considering that all of these spreads are normally used when the trader thinks that there won’t be much movement of the underlying during the period of the trade, it looks like the Iron Butterfly needs to be explored a little further. The reason why we probably don’t hear much about them is that they create a fairly large credit when opening the position. As this isn’t what most brokerages want, they may restrict their use. Check with your broker first.
Butterfly
So before we fortify the butterfly with iron, let’s talk a little about the basic butterfly strategy. The Butterfly has three legs and is composed of
a Bull call spread and a Bear Call spread.
· Buy (1) ITM call at lower strike price
· Sell (2) ATM calls at mid-strike price (closest to forecast average price)
· Buy (1) OTM call at higher strike price.
The same pattern is used if using a call or put but all options must be of the same type and same expiration month. The Butterfly is a Debit spread because the ITM call causes an outlay of more funds than does the credit derived by the sold contracts. Moreover, the further the legs are extended from the mid price, the lower the risk.
Iron Butterfly
Anything with the word iron in it implies strength unless you’re talking about swimming. The addition of the “iron” prefix bespeaks the superiority of the Iron Butterfly over the non iron clad Butterfly. According to the chart at the beginning of the article, The IB has a lower Max loss and the highest Max profit than the other complex spreads. That’s the kind of optimization we want.
There are some distinct differences between the two butterflies. The Iron Butterfly is made up of a Bull Call spread (Buy Call sell a Put) and a Bull Put spread (Buy a Put and sell a call). Also, note that the Iron Butterfly has four legs instead of the Butterfly’s three.
- Buy (1) OTM Put
- Sell (1) ATM Call
- Sell (1) ATM Put
- Buy (1) OTM Call
The Iron Butterfly is a Credit Spread because of the two ATM and no ITM purchases.
Advantages Of Iron Butterfly Spread:
· Able to profit from stagnant stocks.
· Maximum loss and profits are predictable.
· Being a credit spread, it reduces overall risk with a higher probability of ending in a profit than a debit spread.
· Very versatile as the position can be easily transformed into a Bear Call Spread or Bull Put Spread.
Disadvantages Of Iron Butterfly Spread:
· Larger commissions involved than simpler strategies with lesser trades.
For more information and online training on how to use the advanced options strategies contact Options University at www.optionsuniverstiy.com
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