Both the butterfly spread and the condor were designed to be used when stocks are “range-bound.“ They're flexible enough to be directional trades as well, possibly to target a key technical point on a chart. However, they can also play an extremely useful role as the end result of an adjustment of a single option position. Taking a directional trade, such as a long call or put position, and adjusting into a butterfly or condor, may not only allow you to capture some profits, but it may also allow room for future gains.
Of Bugs and Birds
Butterflies and condors alike involve the purchase of one vertical spread, and the sale of another. (Flip to the vertical spread primer on page 30 of this issue for more on verticals.) The short options of both strategies comprise the “inner” strikes (the “body"), while the long options comprise the “outer” strikes (the “wings"). Where those strikes sit makes all the difference between the two (Figure 1).
In both cases, you purchase the trades for a debit. However, the secret to making money on both butterflies and condors lies in understanding time value. Options lose time value as days go by, but some options decay faster than others. Therefore, you want to be short the options that decay faster, and you want to be long the options that decay slower.
Which options decay faster? Those with the most time value, which happen to be those closest to the money. Since all time value has to go to zero by expiration, it also follows that the options with more time value have to get rid of it at a faster rate, than the options with less time value.
As a result, if the trading price of your stock remains close to, or between, the short strikes in your butterfly or condor, your short options would be the ones closest to the money. Since your short options would have the most time value, they would likely exhibit the most time decay. And since the options that you are short would lose more value than the options you are long, that net difference would result in your profit.
To create a butterfly: You buy one vertical spread, and sell another one, whose strikes are equal distances apart, such that the two spreads share the same short strike.
For example, stock XYZ in Figure 1 is trading at $55. You could buy the 50/55 call spread, and subsequently sell the 55/60 call spread. In this case, the body of your spread would consist of the two short 55-strike calls. The wings would be the 50-call, and the 60-call.
Notice that both the long vertical spread, and the short one, are composed of strikes that are $5 apart. Furthermore, both spreads are comprised solely of call options. Finally, both spreads have the same short strike in common.
If you had this position, you would say that you are long the 50/55/60 call butterfly ("call fly” for short).
To create a condor: The idea is the same as the butterfly. But instead of the two verticals sharing the short strike, the trade has two different short strikes. And generally, the strikes pertaining to each vertical spread are the same distance apart. For example, you could buy the 50/55 call spread, and subsequently sell the 60/65 call spread. In this case, the body of your spread would consist of the short 55-strike call and the short 60-srike call. The wings would be the long 50-call and the long 65-call.
Which Is Better?
Because of its construction, a butterfly typically offers a higher potential reward than what can be achieved with a condor, and at a considerably lower debit. On the other hand, the maximum potential reward of condor trades, albeit typically lower than that of butterflies, can span a much wider range of stock prices, thereby theoretically increasing your probability for profit.
In terms of profitability, butterflies and condors have similar properties. In a nutshell, the closer the price of your stock is to the short strikes, the more money you stand to make. For butterfly trades, this means that the closer your stock snuggles up against the short strike at expiration, the more profitable your trade can be.
By contrast, with condors (also Figure 1) there isn't just one stock price at which maximum profit resides. (See Figure 1.) Rather, there is a range of prices. And, because you get to pick the width between the short strikes in a condor, you also pick the width of the range of your potential profit area. The tradeoff is that the wider you make the maximum profit range, the less your maximum potential profit will be.
The good news is that condors can make for very forgiving trades. While so many option strategies expect a certain stock-picking prowess from you, the condor typically only asks that you're “kinda right.” In other words, rather than asking you to pick one stock price, or one market direction, in order to maximize profit, the condor lets you pick a range of stock prices. Depending on the underlying instrument, it allows you to make that stock range quite wide.
Suppose hypothetical stock FAHN is trading in a range between $120 and $130. Perhaps this has been the stock's range for several months. Let's say you looked at trading the 115/120/130/135 condor, expiring in 30 days. In order to achieve maximum profit on this trade, the stock would simply need to stay in its current stock range until expiration. In fact, even if it ventured slightly outside that range, you'd still have a chance to make a little profit.
Now suppose that due to the wide stock range, your maximum profit on this trade would only be 50 cents. For a condor in which each of the vertical spreads is $5-wide, this means that you would be paying $4.50 for the condor. At first glance, this may not sound terribly attractive—a “base hit” if you will.
But a closer look at the math reveals that you have a 10-point range in which you can achieve this maximum profit, and all the stock has to do for the next 30 days is behave as it has for the past four months. How do you know it will perform similarly as it has for the past four months? You don't. Remember, past performance is not a guarantee of future results. It could behave completely opposite of what you expect it to. You could run a probability test on the thinkorswim® trading platform to help assess the likelihood of the stock trading within a certain range. But keep in mind that the probability analysis results are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring. See the sidebar, “Home on the Range.”
So Why Fly?
Simply put, the fly is one way to potentially lock in a partial profit on a winning trade that you might think has more juice. So, suppose you decide to buy a call option, the stock moves to a point of resistance, and you feel that the only choice you have is to exit the position. As it turns out, if you're confident enough in your assessment of resistance, and if you are willing to take on an extra bit of risk, you may be able to squeeze more out of your original long-option position by turning that long option into a butterfly or condor.
Using the butterfly or the condor as an adjustment strategy changes the overall pricing of the trade, and allows you as a trader to judge which of the two strategies best fits your risk tolerance.
Suppose you are bullish on hypothetical stock GVRC, which is currently trading for $203 a share. You think it may make a sudden move to $210, but not much higher, as you notice a lot of resistance at $210.
So, you buy the slightly-out-of-the-money 205 call for $1.60, in an effort to capitalize on a quick move in the stock.
A few days later, GVRC is trading for $208 a share. The GVRC 205 call that you bought for $1.60 can now be sold at $3.60, potentially netting you a $2.00 profit (less transaction costs). You could exit your trade, or you could try to do a little better by securing some of that profit, while turning the trade into a butterfly or a condor.
Turning the trade into a butterfly:
Say you wanted to turn the 205 call into the 205/210/215 butterfly, you would need to sell two of the 210 calls, and buy one of the 215 calls (known as a 2x1 ratio spread). With the stock higher, the 210 calls are trading for $1.40, while the 215 calls are trading for 30 cents. This means that the 210/215 ratio spread can bring in a credit of $2.50 (less transaction costs), thereby giving you a butterfly trade placed for a 90-cent credit (less transaction costs).
You now have a trade that can be worth as much as $5.00, giving you a maximum potential profit of $3.40, plus the 90-cent credit, for a total maximum profit of $4.30 (less transaction costs). Furthermore, if the butterfly happens to go out worthless, you retain the 90-cent credit.
Of course, the $3.40 maximum profit is achieved only if you happen to be lucky enough to have the stock settle exactly at $210, at expiration. The further the stock settles from $210, the smaller your resulting profit. You may be willing to take a smaller credit in exchange for a wider range, for your potential maximum profit.
Turning the trade into a condor:
If you wanted to turn the 205 call into the 205/210/215/220 condor, you would need to sell one of the 210 calls, sell one of the 215 calls, and buy one of the 220 calls. With the stock higher, the 210 calls are trading for $1.40, while the 215 calls are trading for 30 cents, and the 220 calls can be bought for five cents. This means that the 205/210/215/220 condor can be completed for a credit of $1.65 (less transaction costs), thereby giving you a condor trade placed for a net five-cent credit (less transaction costs).
While the net credit on this trade is significantly smaller, the stock range under which you may obtain maximum profit increases from one price point ($210), to a $5-wide range ($210 to $215). This way, if XYZ happens to overshoot the resistance level by a few dollars, you retain some wiggle room where you still can obtain maximum profit.
You now have a trade that can be worth as much as $5.00, giving you a maximum potential profit of $3.40, plus the five-cent credit, for a total maximum profit of $3.45. If your condor happens to expire worthless, you still keep the five-cent credit. Of course, since condors are four-legged spreads, transaction costs should be a consideration. (See page 9, #3 for more details.)
Where Do You Sell?
The resistance level can be helpful in determining which strike or strikes you want to sell, so that they comprise the short options of either your butterfly or condor. The idea is to wait until the stock is close enough to the resistance level so that you sell the options when they are at the money. This way, you would maximize the amount of time value that would work in your favor.
If you are too close to expiration, or if the volatility levels are sufficiently low, you may not be able to obtain enough premium when you sell the body of either your butterfly or your condor. In these cases, it may make sense to simply exit your long option position, and move on to a different trade.
Butterflies and condors are extremely flexible option strategies. You can use them as range trades by selecting short strikes that are close to the current stock price, or as target trades by selecting the short strikes close to where you think the stock will end up. If you are confident of your forecast of exactly where a stock will go, when it will get there and you understand the risks if your forecast is wrong, you can pursue the higher potential profit offered by butterflies. On the other hand, for the mere mortals who may prefer a larger margin for error, you may find comfort in a condor's potentially wider range of profit.