Condors vs. Butterflies: Is there an Ideal Strategy?

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Gabriella Kelley
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1 Condors vs. Butterflies: Is there an Ideal Strategy? September 25, 2012

2 Disclaimer Options involve risks and are not suitable for all investors. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options, sent to you in previous communication. Additional copies may be obtained by calling TRADEKING at KING visiting or by downloading the file in the pop-up window on your screen. Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult a tax advisor. Any strategies discussed and examples using actual securities and price data are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results. Consider the following when making an investment decision: your financial situation, your risk profile and transaction costs. System response and access times may vary due to market conditions, system performance, and other factors. The projections or other information generated by TradeKing's tools regarding the likelihood of various investment t outcomes are hypothetical ti in nature, do not reflect actual investment t results and are not guarantees of future results. The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that these forecasts will be correct. 2

3 Disclaimer All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. You alone are responsible for evaluating the merits and risks associated with the use of TradeKing's systems, services or products. While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility, there is no guarantee that this forecast will be correct. Market timing is a complex investment strategy which involves risk and may incur additional commission costs. Webinars are provided for educational and informational purposes only. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. You alone are responsible for evaluating the merits and risks associated with the use of TradeKing's systems, services or products. TradeKing Group, Inc. 3

4 Condors vs. Butterflies: Is there an Ideal Strategy? Part 1: Condors September 25, 2012

5 What is a Condor? An option strategy consisting of 4 different options 4 different strike prices 2 options are long 2 options are short These options create 2 spreads Generally, the options are centered around the ATM strike OTM and ITM options are used Generally, the options traded are no more than 60 days to expiration 5

6 What is a Condor? An option strategy consisting of 2 spreads One is a long spread The other is a short spread All options have same expiration month Basic strategy ratio is 1:1:1:1 6

7 What is a Condor? An option strategy consisting of 3 main varieties Call Condor (all options are calls) Put Condor (all options are puts) Iron Condor (OTM calls and puts together) Multi-leg l trades Additional risks Multiple commissions May result in complex tax treatments Consult your tax advisor before trading Commissions 4 commissions to enter the position Up to 4 commissions to exit the position Does not include commissions for adjustments 7

8 Structure of Condor

9 Condor examples Call condor: Buy to open 10 June 650 calls (ITM) Sell to open 10 June 670 calls (ITM) Sell to open 10 June 790 calls (OTM) Buy to open 10 June 810 calls (OTM) Put condor: Buy to open 10 June 650 puts (OTM) Sell to open 10 June 670 puts (OTM) Sell to open 10 June 790 puts (ITM) Buy to open 10 June 810 puts (ITM) Iron condor: (used in this presentation) Buy to open 10 June 650 puts (OTM) Sell to open 10 June 670 puts (OTM) Sell to open 10 June 790 calls (OTM) Buy to open 10 June 810 calls (OTM)

10 Profit & Loss areas of the Condor The sweet spot profit area During the trade: stock price or index value has minimal movement and remains close to midway between the short strikes At expiration: stock price or index value is between the break-even points If between short strike and break even point = some gain If at or between short strikes = max gain Maximum loss As stock price or index value moves past either short strike and beyond break-even points As time passes, the loss approaches the max Max loss at expiration at either long strike Break-even points Short put strike less net credit received (iron condor) Short call strike plus net credit received (iron condor) 10

11 What are the objectives when trading a Condor? OTM options expire worthless ITM options exercised / assigned Common to hold position near to or through expiration Optimal conditions include: Range bound or minimal movement in the underlying Lack of news if trading equity options Overall quiet market if trading index options Not intended for trending markets Passage of time Generally, the options traded are no more than 60 days to expiration Static or declining implied volatility Usually seen during quiet markets or uptrending markets Decreasing IV is good, uptrend is not 11

12 Working towards the objectives of the Condor How traders attempt to do this: Probability Calculator and Standard Deviation Define the first standard deviation move If trader expects security to trade within the first standard deviation, select short strikes to coincide with or fall outside of fthe first standard ddeviation Technical analysis Analyze charts to determine the previous range of the security If trader expects range to continue, select short strikes to coincide with or fall outside of the expected trading range Relative Implied Volatility Analysis see Nicole s series How to Choose Your Strategy part 2 A combination of all three or other methods may be used

13 Condor and Probability Calculator

14 Profit & Loss of Condor

15 Iron condor construction Using TradeKing s Probability Calculator as a guide for strike selection: Long (BTO) 10 June 650 puts Short (STO) 10 June 670 puts Short put spread Short (STO) 10 June 790 calls Long (BTO) 10 June 810 calls Short call spread Commissions (4 legs x.65 x 10 contracts per leg) = $30.95

16 Iron condor calculations Long (BTO) June 650 $5.00 Short (STO) June 670 $6.70 Short put spread = $1.70 credit Short (STO) June 790 $3.40 Long (BTO) June 810 $1.70 Short call spread = $1.70 credit Iron condor $1.70 credit from put spread + $1.70 credit from call spread = $3.40 credit

17 Iron condor calculations Iron condor = $3.40 credit Max gain = total credit = $3.40 x 100 x 10 = $3,400 less commissions of $30.95 Max loss = $16.60 x 100 x 10 = $16,600 plus $30.95 comm.» Calculation is the greater of:» = $16.60» = $16.60 Commissions = (4 legs x.65 x 10 contracts per leg) = $30.95

18 Profit & Loss of Condor

19 Profit & Loss of Condor

20 Condor Risk and Reward Reward = $3, (10 contracts including comm.) Risk = $16, (10 contracts including comm.) Reward to Risk ratio = $3, / $16, = 20% Risk is 5 times the Reward Same calc for Return on Investment Is this good? Bad? How do we evaluate this?

21 Condor Risk and Reward Reward compared to Risk is low Both Risk and Reward are limited, but Risk is much greater This Risk profile is characteristic of wide Condors Vigilant Risk Management is critical (#1 priority) Keep distance between strikes of each spread as narrow as possible to reduce capital risk Probability of Reward is high This Probability profile is characteristic of wide Condors Probability Calc indicates almost 70% chance of being profitable 70% chance to make at least one penny, up to 20% return Reward is not guaranteed Note: Condors have multiple commissions

22 Condor: take home message Works best when underlying is expected to be range bound Reward to Risk profile is low Focus is on probability of success (far OTM strikes) Key is finding your short strikes & active risk management Keep distance of strikes for each spread as narrow as possible to keep risk manageable Potential profit needs to be attractive versus risk taken and commissions incurred Many try to hold through expiration but wise to exit with gains sooner due to risk profile Popular to use with indices since generally less volatile than stocks

23 Summary for Iron Condor Figures shown are estimates with no guarantee of reward

24 Condors vs. Butterflies: Is there an Ideal Strategy? Part 1: Condors September 25, 2012

25 Condors vs. Butterflies: Is there an Ideal Strategy? Part 2: Butterflies October 9, 2012

26 Open for Questions

27 Thank you coming! For more information:

28 What is a Butterfly? An option strategy consisting of 4 options 3 or 4 may be different strike prices 2 options are long 2 options are short These options create 2 spreads Generally, the options are centered around the ATM strike ATM, OTM and ITM options are used Generally, the options traded are no more than 60 days to expiration 28

29 What is a Butterfly? An option strategy consisting of 2 spreads One is a long spread The other is a short spread All options have same expiration month Basic strategy ratio is 1:2:1 29

30 What is a Butterfly? An option strategy consisting of 3 main varieties (not including exotics) Call Butterfly (all options are calls) Put Butterfly (all options are puts) Iron Butterfly (calls and puts together) Many advanced varieties (OTM, skip strike, christmas, etc.) Multi-leg trades Additional risks Multiple commissions May result in complex tax treatments Consult your tax advisor before trading Commissions 3 or 4 commissions to enter the position Up to 4 commissions to exit the position Does not include commissions for adjustments 30

32 Butterfly examples Call butterfly: Buy to open 10 June 650 calls (ITM) Sell to open 20 June 730 calls (ATM) Buy to open 10 June 810 calls (OTM) Put butterfly: Buy to open 10 June 650 puts (OTM) Sell to open 20 June 730 puts (ATM) Buy to open 10 June 810 puts (ITM) Iron butterfly: (discussed in this presentation) Buy to open 10 June 650 puts (OTM) Sell to open 10 June 730 puts (ATM) Sell to open 10 June 730 calls (ATM) Buy to open 10 June 810 calls (OTM)

33 Profit & Loss areas of the Butterfly The sweet spot profit area During the trade: stock price or index value has minimal movement and remains close to the short strike price At expiration: stock price or index value is between the break even points If between the break-even points = some gain If exactly equal to the short strike price = max gain Beware of pin risk Maximum loss As stock price or index value moves beyond either break-even point towards either long strike As time passes, the loss approaches the max Max loss at expiration at either long strike Break-even points Middle strike less net credit received (iron butterfly) Middle strike plus net credit received (iron butterfly) 33

34 What are the objectives when trading a Butterfly? Underlying price remains near short strike ATM options remain ATM options OTM options expire worthless ITM options exercised / assigned Close out well before expiration due to small profit area and pin risk Optimal conditions include: Range bound or minimal movement in the underlying Lack of news if trading equity options Overall quiet market if trading index options Not intended for trending markets Passage of time Generally, the options traded are no more than 60 days to expiration Less time = more expensive trade Static or declining implied volatility Usually seen during quiet markets or uptrending markets Decreasing IV is good, uptrend is not 34

35 Working towards the objectives of the Butterfly How traders attempt to do this: Probability Calculator and Standard Deviation If trader expects security to trade within the first standard deviation, select long strikes to coincide with or fall outside of the first standard deviation Technical analysis If trader expects range to continue, select long strikes to coincide id with or fall outside of the expected trading range Relative Implied Volatility Analysis see Nicole s series How to Choose Your Strategy t part 2 A combination of all three or other methods may be used

36 Wide Butterfly and Probability Calculator

37 Wide Butterfly Profit & Loss

38 Wide Iron butterfly construction Using TradeKing s Probability Calculator as a guide for strike selection: Long (BTO) 10 June 650 puts Short (STO) 10 June 730 puts Short put spread Short (STO) 10 June 730 calls Long (BTO) 10 June 810 calls Short call spread Commissions (4 legs x.65 x 10 contracts per leg) = $30.95

39 Wide Iron butterfly calculations Long (BTO) June 650 $5.00 Short (STO) June 730 $21.30 Short put spread = $16.30 credit Short (STO) June 730 $25.00 Long (BTO) June 810 $1.70 Short call spread = $23.30 credit Iron butterfly $16.30 credit from put spread + $23.30 credit from call spread = $39.60 credit

40 Wide Iron butterfly calculations Iron butterfly = $39.60 credit Max gain = total credit = $39.60 x 100 x 10 = $39,600 less commissions of $30.95 Max loss = $40.40 x 100 x 10 = $40,400 plus $30.95 comm.» Calculation is the greater of:» = $40.40» = $ Commissions = (4 legs x.65 x 10 contracts per leg) = $30.95

41 Wide Butterfly Profit & Loss

42 Wide Butterfly Profit & Loss

43 Wide Butterfly Risk and Reward Reward = $39, (10 contracts including comm.) Risk = $40, (10 contracts including comm.) Reward to Risk ratio = $39,569 / $40, = 98% Risk is nearly equal to Reward (1:1) Same calc for Return on Investment Is this good? Bad? How do we evaluate this?

44 Wide Butterfly Risk and Reward Reward compared to Risk is even Both Risk and Reward are limited, approximately equal This Risk profile is characteristic of wide butterflies Risk Management is important Risk can be significantly reduced by reducing distance between long strikes and short strike Probability of Reward is average Probability profile is characteristic of wide butterflies Probability Calc indicates only 50% chance of being profitable 50% chance to make at least one penny, up to 100% return Note: Butterflies have multiple commissions

45 Butterfly: take home message Works best when underlying is expected to be range bound Reward to Risk profile is even (or better; see next example) Focus is on time decay and volatility (ATM strikes) Key is exiting when desired % return is achieved (well before expiration to avoid gamma week and pin risk) Risk management is important Narrow distance between strikes for each spread = lower risk Potential profit needs to be attractive versus risk taken and commissions incurred Popular with stocks or indices

46 Narrow Iron butterfly construction Take same idea with less risk (also less reward) Long g( (BTO) 10 June 710 puts Short (STO) 10 June 730 puts Short put spread Short (STO) 10 June 730 calls Long (BTO) 10 June 750 calls Short call spread Commissions (4 legs x.65 x 10 contracts per leg) = $30.95

47 Narrow Iron butterfly calculations Long (BTO) June 710 $15.00 Short (STO) June 730 $21.30 Short put spread = $6.30 credit Short (STO) June 730 $25.00 Long (BTO) June 750 $15.10 Short call spread = $9.90 credit Iron butterfly $6.30 credit from put spread + $9.90 credit from call spread = $16.20 credit

49 Narrow Iron butterfly calculations Iron butterfly = $16.20 credit Max gain = total credit = $16.20 x 100 x 10 = $16,200 less commissions of $30.95 Max loss = $3.80 x 100 x 10 = $3,800 plus $30.95 comm.» Calculation is the greater of:» = $3.80» = $3.80 Commissions = (4 legs x.65 x 10 contracts per leg) = $30.95

50 Narrow Butterfly Profit & Loss

51 Wide Butterfly Profit & Loss

52 Narrow Butterfly Risk and Reward Reward = $16, (10 contracts including comm.) Risk = $3, (10 contracts including comm.) Reward to Risk ratio = $16, / $3,831 = 422% Risk is one-fourth the Reward Same calc for Return on Investment Is this good? Bad? How do we evaluate this?

53 Narrow B-fly and Probability Calculator

54 Narrow Butterfly Risk and Reward Reward compared to Risk is high This Risk profile is characteristic of narrow butterflies Risk management is less important Risk has been significantly reduced by narrowing distance between strikes Probability of Reward is low Probability profile is characteristic of narrow butterflies Probability Calc indicates only 21% chance of being profitable 21% chance to make at least one penny, up to 422% return Note: Butterflies have multiple commissions

55 Summary for Wide Iron Butterfly Figures shown are estimates with no guarantee of reward

56 Summary for Narrow Iron Butterfly Figures shown are estimates t with no guarantee of reward

57 Summary for Iron Condor Figures shown are estimates with no guarantee of reward

58 Side by Side Summary Figures shown are estimates with no guarantee of reward

59 Condors vs. Butterflies: Is there an Ideal Strategy? Part 2: Butterflies October 9, 2012

60 Open for Questions

61 Thank you coming! For more information:

Skip Strike Butterflies: Setup, Risks, and Uses. Disclaimer 2/21/2012

Skip Strike Butterflies: Setup, Risks, and Uses Disclaimer Options involve risks and are not suitable for all investors. Prior to buying or selling options, an investor must receive a copy of Characteristics