From our friends at OptionAlpha
Are you new to options trading?
Do you have a small account and want to start trading iron condors and iron butterflies?
Today’s post will be very important as we help you understand how to calculate breakeven prices on iron condors and other risk defined strategies the correct way.
Plus, we’ll walk through a multi-month adjustment to an existing IWM iron butterfly in which we nearly doubled the credit received by rolling contracts to the next expiration period.
- A simple options strategy where by you are selling a spread on either side of the market
- If the stock is trading at $100, you might sell the $105 call option and buy the $106 call option
- This creates a $1-wide call spread above the market.
- If the stock is trading at $100, you might sell the 95 strike put option and buy the 94 strike put option
- This creates a $1-wide spread below the market.
- The combination of two spreads on either side of the market creates the iron condor payoff diagram.
- You generally want to see the stock move between your short strike prices.
- If the stock moves between your strike prices and ends between your prices, then you take in all the credit possible at the expiration
What happens if the stock moves just a little bit beyond those strike prices?
- You don’t lose automatically.
- This is where break-even prices come into play.
Sold the call spread 25 cents (the 105-106 call spread). Then also sold the put spread for 25 cents. Together this gives you a collective credit of 50 cents. This collective credit now moves your break-even point out 50 cents on either end from your short strikes. That means the true break-even points are now 105.50 on the call side and 94.50 on the put side, which is 50 cents wider than your short strike prices.
*The credit is always based off of the addition and subtraction of the credit from the strike prices of the short strikes.
- Generally, the markets are pretty fair and efficient when it comes to pricing in these credits and break-evens.
- If you have a wider spread on either end of your Iron Condor, then that means you generally are going to take in a bigger net credit, which means that your break-even points are going to be a little bit wider.
- Therefore you will potentially have a wider profitable range to catch the stock in.
- In order for you to get the benefit of that wider range and potentially higher win-rate, you will have to take on a little bit more risk (in the form of a wider spread).
- The same concept as with Iron Condors is true, except now we’re dealing with a much larger credit.
- With an Iron Butterfly, you are selling premium at the money on both the short call and the short put.
If a stock is trading at $100, to create an Iron Butterfly strategy you would sell the $100 strike put and the $100 strike call. Then you would buy the same, 106 call and 94 strike put.
This will generally have a very similar overall potential probability of profit.
Assume that you take in a net credit for the inside legs of $5.25. That $5.25 that you take in as a net credit for selling the at the money strikes moves your break-even point out $5.25 on either end. You effectively get a very similar payoff diagram as far as break-even points, it’s just the distribution of your profits are a little bit different.
- With an Iron Butterfly, you are taking in all of your credit right now.
- Now you are taking in a much higher credit so that if the stock lands closer to where the stock is trading now (meaning it moves more sideways), you make a lot more money on an Iron Butterfly.
— The Option Specialist