You’re looking at a great setup for a neutral trade, but which neutral strategy do you use? Short straddle or short iron butterfly? It’s a question we get all the time and today’s podcast focuses exclusively on the trade-offs of using one strategy over the other. And while both strategies are built using the same core short straddle position, the choice of adding protection or not using long OTM options can sometimes lead to analysis paralysis. So, let’s clear this hurdle together.
Key Points from Today’s Show:
- A short straddle is comprised of a short, at the money call option and a short, at the money put option.
- Both the call and the put option are sold at the same strike price.
- This allows you to straddle the market, collecting as much premium as possible.
- This moves your break-even-point out by the distance of the premium you collected.
If the stock is trading at $100, you would sell the $100 strike call and the $100 strike put. If you collect a $5 premium, your break even points are $5 above and $5 below the at the money strikes. This creates a range between 95 and 105.
- Short straddles are naked, undefined risk positions.
- This means you have to keep your position size extremely small.
- You also have to keep your overall exposure to short straddle trades small in your account.
- Keep in mind, margin can expand very quickly during periods of high implied volatility.
Short Iron Butterfly
- The short iron butterfly is the synthetic equivalent of a short straddle, with one exception.
- With the short iron butterfly, you buy outside wings to define your risk and create forced protection.
- This can be a two credit spread or an inside short straddle and an outside long strangle.
- Now, this creates four legs: two at the money short strikes, and two out of the money call option and put option on either side.
First, sell the at the money call at $100 and sell the “at the money” put at $100. Next, buy the $110 strike call option and the $90 strike put option – $10 out on either end. This gives you a defined risk position, containing and controlling risk and margin much more efficiently than a short straddle.
*The tradeoff: spend a little bit of extra money in exchange for less risk.
- When choosing between a short straddle and a short iron butterfly, it all depends on how much risk you are willing to take.
- Just because there is less risk does not necessarily mean that you will make more money.
Pricing Out Straddles
- With straddles, you are generally looking for the highest ROI.
- Choose the trade that pays the most premium per unit of risk.
- Generally, you will get better pricing on straddles for higher IV stocks and ETFs.
In straddle A, you put up $2,000 and you are able to collect a $50 credit.
This means you take in 2.5% return on the possible risk.
In straddle B, you put up $10,000 but you are able to collect a $500 credit.
This is 5% of return per unit of risk.
Pricing Short Iron Butterflies
- With short iron butterflies, set them up very similar to one another.
- When considering two different tickers, set up a $5-wide or $10-wide short iron butterfly on both and see which one prices out the best.
- To learn more about the rationale behind picking trades, listen to Show 143.
Example: EFA – Emerging Market ETF
EFA is trading around $61
To build out an iron butterfly, sell the $61 put and the $61 call
Next, you go out $5 from $61 to the $66 price point for EFA – the cost is $1 for everything above $66.
This means that you can protect your risk of $500 for $1.
If it’s this inexpensive, it is not likely for it to get above $66.
So if you come in a bit on your call option long strike price, it will reduce the width of the call side spread and reduce risk.
The $65 call options are priced at $3, to protect a risk of $400.
This means risk is cut by $100 and only cost an extra $2 – can you keep cutting risk even more?
Looking at the $64 call options, they are priced at $42.
The risk is reduced by $100 but costs $42, which is not the best price.
Therefore, the best option is to buy the $65 call options.
*A 10 Delta on either end is a great starting point to start this analysis.
Tradeoffs: Straddle vs. Iron Butterfly
- Short straddles make more money than short iron butterflies.
- Looking at the top 10 trades of each:
- The best short straddle makes an annual CAGR of 3.64%.
- The best iron butterfly makes an annual CAGR of 1.69%.
- With straddles, you are trading naked, undefined risk position.
- This leaves you open to potentially bigger drawdowns.
- The top straddle had a 51% drawdown at some point during the trade.
- The top iron butterfly had a 42% drawdown.
*When you trade straddles you get a higher return and make more money, but in exchange you give up the stability of your portfolio.
- Short straddles have a much higher win rate than iron butterflies.
- This is mostly because it’s pure options selling, so you have shorter durations in the trades.
- The top short straddle won at 70.22%.
- The top iron butterfly won at 66.8%.
The Differences: Straddles vs. Iron Butterflies
- As a general rule, don’t use straddles on stocks or ETFS that are over $100.
- For example, if the stock is $1,000 then the margin to hold the straddle is extremely high.
- When the stock price is below $100, then you have to look at implied volatility.
- If IV is high, choose a straddle-type trade: pure straddle or very wide iron butterfly.
- When IV is low, trading iron butterflies is preferable.
- During a period of low IV, there can be a spike in IV at any time, which can create huge risk.
- Therefore, the iron butterfly will help to protect against this potential risk.
Free Options Trading Courses:
- Options Basics [20 Videos]: Whether you’re a completely new trader or an experienced trader, you’ll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
- Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an “edge” in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
- Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We’ll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
- Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You’ll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
- Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we’ll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
- Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can’t seem to get answered, then this section will help you.
- Portfolio Management [16 Videos]: When I say “portfolio management” some people automatically assume you need a Masters from MIT to understand the concept and strategies – that is NOT the case. And in this module, you’ll see why managing your risk trading options is actually quite simple.
- Trade Adjustments/Hedges [15 Videos]: In this popular module, we’ll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we’ll help you create an alert system to save time and make it more automatic.
- Professional Trading [14 Videos]: Honestly, this module isn’t just for professional traders; it’s for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.
Option Trader Q&A w/ Brett
Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Brett.
When trading iron condors and iron butterflies inside an IRA account, buying and selling are straightforward but adjustments are a nightmare, especially for the short calls. Any suggestions on doing that today, or will this be addressed by the Option Alpha automatic trading app?
Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.
PDF Guides & Checklists:
- The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
- Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
- Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
- Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
- When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we’ll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
- 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.
Real-Money, LIVE Trading:
- EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
- VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
- DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we’ll discuss why I’m adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
- COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
- TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
- MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
- IBB Call Debit Spread (Opening Trade): We’ll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
- TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly – even still the drop in implied volatility helped generate a $330 profit for us.
- XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
- COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
- EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
- IBM Iron Condor (Earnings Trade): Shortly after the market opened you’ll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
- SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.
Thank You for Listening!
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