Iron Butterfly And Condor Slices

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1 Stocks & Commodities V. 26:2 (2-26, 28, 0): Iron Butterfly And Condor Slices by Tony Saliba and Joe Corona Capturing Trend Transitions Iron Butterfly And Condor Slices This option strategy may be effective when the market is transitioning from trending to trendless. M by Tony Saliba and Joe Corona arkets, market sectors, and individual stocks can cycle between states of price balance and imbalance. An underlying market, market sector, or stock is in a state of price balance when there is equilibrium between buyers, sellers, and the underlying market moves in a trendless or sideways fashion. A market is in a state of price imbalance when buyers overwhelm sellers and prices trend higher, or sellers over- whelm buyers and prices trend lower. An imbalanced (trending) market will eventually reach a price where sufficient buying or selling is attracted to correct the imbalance and the market will begin to move in a trendless fashion until the next event pushes it into imbalance, and the process starts over. Capturing and profiting from the transition from a trending market to a trendless market is a tricky business. Expressions such as the trend is your friend, never try to pick the top, and never catch a falling knife can be found in most trading literature (and overheard in the bars near the exchanges). However, these common expressions tend to apply more to trading the underlying stocks or futures than options on those stocks or futures. JOHN NEBRASKA

2 The unique properties of options, including option spreads may allow traders P&L to violate some traditional rules of trading without leaving themselves exposed to the unlimited risk of a naked position in underlying contracts. By combining options into spread strategies, traders can take positions that can fit the complex scenarios that occur when markets en ter a transitional or pretransitional phase. One such structure that may be effective for entering a market that appears to be transitioning from trending to trendless is the long iron butterfly or condor. Stocks & Commodities V. 26:2 (2-26, 28, 0): Iron Butterfly And Condor Slices by Tony Saliba and Joe Corona g y p 5 FIGURE : LONG BUTTERFLY VALUE VS. TIME TO EXPIRATION PROFITING FROM A DIRECTIONLESS MARKET So what type of option strategies will potentially profit from a trendless market? If a market is trendless, hovering around the same prices every day or floundering inside a trading range, the only thing really changing on a day-to-day basis is the passage of time. So it follows that those option strategies that are neutral in terms of direction, but benefiting from the passage of time strategies with positive time decay may be ways to address a directionless market. TIME DECAY The price of an option has two component values, intrinsic and extrinsic. Intrinsic value is the amount by which an option is inthe money. A call option is in the money if the price of the underlying is above the strike price. A put option is in the money if the price of the underlying is below the strike price. Any remaining value is extrinsic value. At-the-money options and out-of-the-money options are composed entirely of extrinsic value. Extrinsic value in an option depends on many factors including underlying price, interest rates, dividends, time until expiration, and im- plied volatility. Theoretically, an option loses a 2 portion of its extrinsic value every day, and over P&L time, an option will lose all of 0 its extrinsic value. This is time decay. Because of time decay, buyers of options theoretically lose money Stock Price Stock Price FIGURE 2: LONG CONDOR VALUE VS. TIME TO EXPIRATION A long iron butterfly or condor is a limited risk position that is the synthetic equivalent of a traditional long call or put butterfly or condor. every day, while sellers of options theoretically gain money every day. At-the-money options contain more extrinsic value than in-the-money options or out-of-the-money options, and therefore decay at a faster rate. Long butterflies and condors can be structured to address this, with the inside body strikes composed of short options and the outside wing strikes composed of long options. This results in the properly positioned long butterfly or condor having positive time decay, which means, theoretically, the passage of time will add to the profitability of the position. The effect of the passage of time on the profitability of an at-the-money long butterfly is illustrated in Figure and that of the condor position in Figure 2. STRUCTURE A long iron butterfly or condor is a limited risk position that is the synthetic equivalent of a traditional long call or put butterfly or condor. The differences in structure are illus- expiry d 2d d d 5d 7d 0d 20d expiration day 2 days days days 5 days 7 days 0 days 20 days

3 Stocks & Commodities V. 26:2 (2-26, 28, 0): Iron Butterfly And Condor Slices by Tony Saliba and Joe Corona Strike Call Butterfly Put Butterfly Iron Butterfly K K K FIGURE : LONG BUTTERFLY STRUCTURES. A long iron butterfly is a limited risk position that is the synthetic equivalent of a traditional long call or put butterfly. Here you see the differences in the structures. Strike Call Condor Put Condor Iron Condor K K2 K K FIGURE : LONG CONDOR STRUCTURES. Here you see the differences in the condor structures Historical Support FIGURE 5: LONG IRON BUTTERFLY AND CONDOR TRADING, SCENARIO. Here the stock has been in a sharp downtrend and is now severely oversold at high implied volatility levels and is approaching a historical support level. trated in Figures and. A close examination of these tables reveals that long butterflies and condors are composed of vertical spreads; bull vertical spreads at the lower two strikes, and bear vertical spreads at the upper two strikes. Since a long butterfly is usually structured over three adjacent strikes, the bull and bear vertical spreads overlap at the middle strike. Since a long condor is usually structured over four adjacent strikes, the bull and bear vertical spreads are adjacent to one another. The iron versions of these structures are also composed of overlapping or adjacent bull and bear vertical spreads. The difference is that the spreads are both credit spreads, meaning the bull vertical spread portion of the structure is a short put spread, and the bear vertical spread portion of the structure is a short call spread. The iron versions of the long butterfly and condor also reveal the embedded volatility positions; the long iron butterfly is composed of a short straddle bracketed by a long strangle, while the long iron condor is composed of a short strangle at the two inner strikes bracketed by a long strangle at the two outer strikes. Since they are generally synthetically equivalent, long call, long put, and long iron butterflies and condors all have similar risk, reward, and breakeven profiles when traded at fair value. Position A TRADING VEHICLE Because long iron butterflies and condors are usually composed of out-of-the-money credit spreads they are generally easier to trade into and out of in stages or legs, because the bid ask spreads of out-of-the-money options are usually much tighter than those of in-the-money options. In addition, since an iron butterfly or condor is composed of both a bullish credit spread and a bearish credit spread, the entire position may be deployed in stages, depending on the current market view of the trader. This makes it a trading vehicle for capturing a market transitioning from trending to trendless. The vertical spread subcomponents of the long iron butterfly or condor allow the trader to establish bullish or bearish positions in limited-risk slices of moderate volatility exposure rather than the open-ended risk of a short put or a short call, or the volatility exposure of a long put or a long call. One vertical spread portion of a long iron butterfly or condor can be deployed when the trader believes the market has become oversold or overbought, while the other portion can be added when the trader feels the bounce or correction has run its course and the underlying will begin the range trade of a trendless market. This could occur in any time frame, days or weeks, even months. If the range becomes firmly established within support and resistance levels, the trader can milk the position by lifting the vertical spread legs of the long iron butterfly or condor when the underlying reaches the top or bottom of the range taking profits on the bull vertical spread at the top of the trading range and then reestablishing it at the bottom of the range, or taking profits on the bear vertical spread at the bottom of the trading range and reestablishing it at the top of the range. The trader may also choose to trade in and out of the long and short volatility positions embedded in the long iron butterfly or condor as implied volatility levels rise and fall. LONG IRON BUTTERFLY AND CONDOR TRADING SCENARIOS Scenario I (Figure 5) XYZ has been in a sharp downtrend for some time and appears to be severely oversold at high implied volatility levels and is approaching historical support near The trader: ) Is anticipating a bounce but is wary of bottom-picking with open-ended risk. On the other hand, he does not want to go long calls because of high-volatility levels. The trader decides to position the slice by selling

4 Stocks & Commodities V. 26:2 (2-26, 28, 0): Iron Butterfly And Condor Slices by Tony Saliba and Joe Corona FIGURE 6: LONG IRON BUTTERFLY AND CONDOR TRADING, SCENARIO 2. The stock had a cataclysmic drop and there is no support in sight. Implied volatility has gone through the roof. the put spread, a limited-risk bullish position with a short volatility bias. 2) Is correct and XYZ bounces off of support near the level. XYZ moves slowly up toward and implied volatility backs off. The position is profitable. ) Decides the correction has run its course and near-term resistance is forming at the level. The trader also believes that a range trade is forming between and and decides to complete the position by selling the call spread, a limited risk bearish position with a short volatility bias. ) Is now long the 80/85/90/95 iron condor and is positioned for a trendless range trade. Scenario II (Figure 6) ABC has had a cataclysmic drop due to bad news. No support is in sight and implied volatility has gone through the roof. The series of events could include: ) The trader would like to sell some volatility but does not want any downside exposure as there is no apparent support. The last area of support is a good 0 points above the current price and the trader believes the chance is remote of ABC trading back up to this area. The trader decides to position the slice by selling the call spread, a limited-risk bearish position with a short volatility bias. Previous Support 2? Position 2) ABC begins to find support just above the level. ) The trader decides the support above looks as though it will hold for the time being and that a range trade is forming between and. The trader decides to complete the position by selling the put spread, a limited risk bullish position with a short volatility bias. The trader is now long the 80/85/95/00 iron pterodactyl and is positioned for a trendless range trade. ) After an outside day with a lower close, the trader believes the downtrend might be set to resume and closes the bullish portion of the iron pterodactyl, leaving a bear spread. THE PTERODACTYL In the previous example, the trader entered into a long iron pterodactyl position. A long pterodactyl is a long condor (or long butterfly) with additional long butterfly or butterflies embedded in the position. The net result is a wider coverage area for the position. Figures 7 and 8 illustrate the structure of a long pterodactyl. Scenario III (Figure 9) DEF has broken sharply into support and now appears oversold with high-volatility conditions. The trader: ) Is anticipating a bounce but is wary of bottom-picking with open-ended risk. On the other hand, he does not want to go long calls because of high-volatility levels. The trader decides to position the slice by selling the put spread, a limited risk bullish position with a short-volatility bias. Strike Call Butterfly + Call Butterfly + Call Butterfly = Call Pterodactyl K K2-2 K -2 K -2 K5 FIGURE 7: DECOMPOSITION OF THE LONG PTERODACTYL. A long pterodactyl is a long condor (or long butterfly) with additional long butterfly or butterflies embedded in the position. The net result is a wider coverage area for the position. Strike Call Pterodactyl Put Pterodactyl Iron Pterodactyl K K2 K K K5 FIGURE 8: LONG PTERODACTYL STRUCTURES

5 Stocks & Commodities V. 26:2 (2-26, 28, 0): Iron Butterfly And Condor Slices by Tony Saliba and Joe Corona FIGURE 9: LONG IRON BUTTERFLY AND CONDOR TRADING, SCENARIO. The price of the underlying has broken sharply into support and is now oversold with high volatility conditions. 5 6 FROM TRENDING TO TRENDLESS There are endless iron butterfly/condor/pterodactyl scenarios that can be utilized in the transitional trade from a trending market to a trendless one. Using limited-risk slice bets with the vertical spread subcomponents may allow traders to build the structure in stages at advantageous prices, and to trade from within the structure to capture trading range swings while operating with limited risk in all directions. Options are sophisticated investment vehicles and are not suitable for all investors. In addition to important tax considerations, strategies involving multiple options will 2) Is correct and DEF bounces off of support near the level. DEF moves slowly up toward and implied volatility backs off. The position is profitable. ) Decides DEF is going to swing in a large range contained by the support level and overhead resistance near for a long period of time. The trader would like to aggressively trade these swings while remaining in a short volatility position and sells the call spread on a rally into resistance. The trader is now long the 85/90/95/ 00 iron condor., 5, 6) The trader now scalps the trading range by liquidating the bull spread portion of the iron condor on rallies and then reapplying it on selloffs; liquidating the bear spread portion of the iron condor on selloffs, and reapplying it on rallies. incur additional commission costs; both of which will affect the total profit or loss. To receive a copy of the Options Disclosure Document please contact David Schmueck at Member SPIC. Anthony J. Saliba is a trader and an internationally recognized consultant on the emergence and functions of electronic markets and trading systems. SUGGESTED READING Gopalakrishnan, Jayanthi [2008]. Trading Options With Anthony J. Saliba, interview, Technical Analysis of STOCKS & COMMODITIES, Volume 26: May. Saliba, Anthony, Karen E. Johnson, and Joseph C. Corona [2008]. Option Strategies For Directionless Markets, Bloomberg Press. Saliba, Anthony, and International Trading Institute [2005]. The Options Workbook, Kaplan Business. Schwager, Jack D. [989]. Market Wizards: Interviews With Top Traders, Prentice Hall Trade. S&C

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