Iron Condor and Butterfly Spread Thoughts
Today will be discussing the difference between the Iron Condor and the Butterfly spread. Although these two trades have very different titles, they both carry very similar risks and similar option Greeks characteristics. In this article we will point out some interesting facts about the two popular option spreads.
Both of these trades are tough to manage because they are exposed to risk on the downside as well as the upside. Traders refer to this risk as gamma risk, meaning the flat delta positions changes really fast. The other weakness in the structure is that they possess a poor Decay Rate Ratio™ (DDR™).
Decay Rate Ratio™ (DRR™) is a trademark of San Jose Options. The concept was invented by founder, Morris Puma and may not be used without our written consent.
Morris determined that the “theta” of a trade was not nearly as important as the “decay rate ratio™” of a trade. The DRR™ can be calculated by comparing the actual decay rate of each option. OTM contracts typically decay faster than ATM, even though ATM have a higher theta. Traders are typically drawn to selling ATM because theta is higher there, but they don’t realize those options are actually decaying at a slower rate. This is one very important point to understand about Theta that is very commonly misunderstood throughout the industry.
Although they are both positive theta trades, the iron condor and butterfly spread are structured such that the long contracts decay faster than the short contracts, giving them poor DDR™ structures. Therefore, these are not strong theta structures as traders believe.
The butterfly has an even worse DDR™ than the Iron Condor. The reason the DDR™ is worse on the Butterfly is because the short strikes on the butter are typically placed near the money and the shorts of the IC are placed OTM. This is the primary difference in the structure of the two spreads.
Although the Decay Rate Ratio™ is worse on the Butterfly spread, it offers slightly more safety if the underlying asset drops rather quickly. The reason for this is because again, the long contracts are farther away from the short contracts in the Butterfly compared to the Iron Condor, and therefore, the Butterfly technically could have more positive Vomma than the Iron Condor does.
SUM IT UP
The Butterfly will typically have a worse Decay Rate Ratio™ than the Iron Condor, but it will have more positive Vomma which makes it slightly safer if there is a crash of your underlying asset. However, please note that neither of these option strategies is safe. I wouldn’t want to be in either one during a volatile market move without some sort of hedge. Finally, the comments about the volatility risk assumes that there is an inverse correlation between price action and volatility of your underlying.
I hope you’ve learned something new about options from this article, and if you would like more information about our mentoring program, please don’t hesitate to contact us. We are here to help.