Comparing sideways market strategies
Markets as a whole—and even individual stocks—not only move up or down but they can move sideways or be range-bound, often for great lengths of time. If you anticipate just such a situation, then there are two excellent credit-generating option strategies at your disposal: The iron butterfly and the iron condor. Let’s examine both of them and decide which one is better (although both are good).
Let’s begin with the iron butterfly. Simply put, the iron butterfly is short the at-the-money (ATM) straddle and long the out-of-the-money (OTM) strangle. It is a credit strategy because the ATM straddle will be trading higher than the OTM strangle. This means that you will sell the straddle for more than you will buy the strangle. The iron butterfly puts the clock on your side because the straddle will decay faster than the strangle. The profit/loss graph is shown in “Iron butterfly profile” (right).
You are long an OTM put (strike A), short both the ATM put and the ATM call (strike B), and long the OTM call (strike C). So, you are short straddle B and long strangle A/C. This means your maximum profit is an expiration at exactly strike B. Also, your risk is strike B minus strike A minus the net credit. We also have two breakeven points: Strike A plus the net credit received, and strike C minus the net credit received. It is very important that all strikes must be equidistant from each other for accurate risk vs. reward calculations.
For the trade to be truly direction neutral, the straddle must be as close to exactly at-the-money as can be. To do otherwise is directional guesswork and that’s not what this discussion is about. The only direction we are choosing is non-direction—that is, a sideways, range-bound market.
The obvious question is where to set the wings. In other words, what strangle do we buy? Consider the tenet to take what the market gives you. Where, in its wisdom of supply and demand, does the market as a whole think the range will be? For this, we will use the ATM straddle. In a liquid stock or index, supply meets demand at what the market thinks the range of movement will be. Let’s say XYZ is trading at $50, and the 50 straddle is trading at $5.00. That means the buyer of the straddle thinks XYZ will be outside the 45-55 range at expiration and the seller thinks expiration will be within 45-55. We call these our measured move targets (MMT).
Let’s look at options on the extremely liquid exchange-traded fund that tracks the Standard & Poor’s 500 (ticker symbol SPY).
Say that as year-end 2014 approached, we believed that after a volatile past few weeks, the market would settle down through the holiday period. With SPY trading on Nov. 12, 2014, at 203.96, we might use the December 204 straddle to give us our MMT. The December 204 straddle was trading at 6.30 (3.00 in the call and 3.30 in the put). This gives us MMTs of roughly 198 and 210 (see “SPYing the MMT,” below).
To put on the iron butterfly, we sell the December 204 straddle at 6.30 and at the same time buy the 198-210 strangle at 2.10. That is 1.50 in the put and 0.60 in the call (that’s quite a tilted skew, but that’s grist for another article).
At this point, you should ask yourself, what is the maximum reward, maximum risk and where does the position break even? An expiration on the third Friday of December exactly at our short strike (strike B) gives us our maximum profit, which is the credit we received: 4.20 or $420 per iron butterfly.
Remembering that the risk is strike B minus strike A minus the net credit; we risk 1.80, or $180, on any expiration below 198 or higher than 210, and our two breakeven points are strike A plus the net credit received and strike C minus the net credit received, or 202.20 and 205.80. Anywhere in between, the position makes money and ideally we want all four options to expire worthless.