Iron Condors and Butterflies: Neutral Strategies for Volatile Markets

Market volatility happens when there are unpredictable price swings for options and other securities, which can lead traders to use strategies that are based around market direction or price speculation. But what happens when it looks like the market is neither going to trend upward nor downward in a defined direction? This is when traders can respond with neutral strategies that are designed to profit in uncertain conditions.

In this guide, we’d like to walk you through a few neutral strategies that work well in slightly volatile markets: the iron condors and butterflies (butterfly spreads). These two are range-bound plays that can secure the trade a profit when the price of the underlying asset remains within a certain range of price points, not breaking out in either direction significantly. We’ll take a deep dive into each and give you a good idea of how to best implement them into your trading plan. Make money even when market or price direction is uncertain!

What Are Neutral Options Strategies?

Understanding the nature of neutral options strategies requires a clear idea of what a “neutral” market outlook is among options traders. This refers to a market that is neither bearish nor bullish. The general consensus among traders and inventors is that the market will not increase or decrease significantly in the near future. The expectation is that price fluctuations will be minimal, which ultimately results in a market that isn’t rocked by volatility and extreme price swings.

Neutral Options Trading Explained

Based on the options strategies they are using, traders can make money in neutral markets just as easily as they can lose money. While there isn’t a dominant trend to use as a point of reference, the prices may move in a limited range, which will require traders to use strategies that make money from these choppy patterns and sideways movement. Strategies that tend to work well in these conditions are straddles, strangles, and other market-neutral moves.

Why Use Neutral Strategies Instead of Directional Trades?

The big reason to use neutral strategies in sideways or choppy markets instead of directional trades is to generate profits no matter if the market goes up or down. It’s not so much about trying to speculate on future price movements as you would with directional trades—it’s about exploiting the relationship between assets or price inefficiencies, and it can be a much less risky proposition than using directional trades.

Perks of Neutral Strategies

• They can diversify a portfolio beyond the typical long-only positions that traders will have when using directional trades.
• Traders can take advantage of neutral strategies to collect premiums using moves like selling options or covered calls.
• Using neutral strategies offers more opportunities for traders beyond directional or speculative positions. Neutral moves let traders make money from arbitrage, discrepancies in prices, or statistical relationships.
• A great thing about neutral strategies is that they can reduce the possible impact of adverse market price movements on your collection of positions. These strategies carry a lot less market risk.
• Traders can use neutral moves in combination with directional strategies, and this can offer a nice level of flexibility in the options trading experience.

Examples of When Markets Appear Volatile but Trendless

During periods where the market isn’t following a well-defined trend, but is characterized by a higher level of volatility, it can see considerable price movements that could happen day-to-day or even week-to-week. It’s what’s known as a “sideways” market, and it will have price fluctuations within a certain range, but these prices won’t be pulling strongly one way or the other. If you look at the patterns over the long term, you’ll see that the prices return to roughly the same level, and this presents no visible trend in either direction to those studying them.

Strategy Deep Dive—Iron Condors

The iron condor is a market-neutral strategy for trading options where the trader profits from the price of the underlying asset staying within a certain range and not experiencing major price swings in either direction. The iron condor is largely successful when the market is experiencing a decrease in implied volatility and from time decay that inevitably happens when the options contracts used to build the iron condor draw nearer to their expiration date.

How Iron Condors Work

The iron condor is constructed by combining a bull put spread and a bear call spread. The put spread consists of a short put and a long put, which symbolize selling a put option and buying a put option, respectively. The entire spread usually has a lower strike price than the short put. The other half (the call spread) is made of a short call and a long call where the strike price for the whole spread is higher than the strike price of the short call.

Ideal Market Conditions

Consider using the iron condors strategy when the market is experiencing low-to-moderate volatility, when many traders have a range-bound outlook. The entire reason the iron condor is considered a neutral strategy is for the fact that it profits best when used in range-bound markets where the price of the underlying is expected to trade within a narrow range.

Risk/Reward Profile

The iron condor has a defined risk and reward profile, which means that the highest possible win and loss are known to the trader who commits to the position. The highest potential gain for the iron condor is capped at the net premium that the trader receives for initiating the trade. The worst loss that a trade can incur with an iron condor is if the price of the underlying moves significantly beyond the higher long call strike or the lowest long put strike by the expiration date.

• Maximum Loss Calculation: Take the width of the spread, which is the difference between the strike prices of the short and long options, and subtract the initial credit you received for starting the trade.
• Breakeven Points: Iron condors have two breakeven points, one being the downside breakeven and the upside breakeven. Traders can calculate the lower breakeven point by subtracting the net premium from the short put strike price. The higher breakeven is determined by adding the net premium to the short call strike price.
• Margin Requirements: Traders who are using the long iron condor can figure out their margin requirements by taking the cost of the spread for the long option and subtracting the credit received from the short option. For the short iron condor, the margin requirement is determined by the difference between the strike prices of the short and long options, which is then multiplied by the number of contracts being used.

Pros & Cons

Although there are several great perks to using the iron condor in range-bound markets, it isn’t a perfect strategy with harmonious outcomes only. You can run across a few drawbacks using the iron condors, and you should know these downsides before using these trading strategies. Below, we’ll run through the iron condor’s main pros and cons for your convenience.

Advantages

• Defined Risk—The maximum loss for the iron condor is limited and is known at the onset of the trade. At the same time, the highest profit potential is capped at the net premium received for initiating the trade, and that is known from the start as well.
• Flexible Range Play—Iron condors offer a nice degree of flexibility to traders using them. For instance, these traders have customizable strike choices allowing traders to choose the distance of the strikes from the current price and the width of the spread. This lets them adjust the risk and reward profile to make it fit as best as possible with their trading plan.

Drawbacks

• Limited Profit—The profit of the iron condor is limited to the premium the trader gets upfront when they sell the four options that make up the trade. Compared to other types of strategies, the iron condor has a lower ceiling of profit potential.
• Vulnerability to Large Price Swings—Iron condors are a bet against large price movements, and these events can be the undoing of the trade. The maximum loss for an iron condor can be incurred if there is a significant movement beyond the established range set worth at the beginning of the trade.

Strategy Deep Dive—Butterfly Spreads

Now that we have enlightened you on how an iron condor is structured and when it is best to use, let’s look at another neutral strategy for trading options in volatility markets called the butterfly spread. This one is set up a bit differently, but it does share quite a bit in common with the iron condor. The key to understanding the difference between the two is that the iron condor has a wider profit range, while the butterfly spread has a narrower range but the potential for much higher profits overall.

What Is a Butterfly Spread?

The butterfly spread refers to an options strategy where traders are buying and selling options at three different strike prices. The goal is to profit from limited price movements within a range-bound market. The butterfly spread can be put together using just call options or just put options, but it cannot be a combination of both.

Types of Butterfly Spreads

Traders should be aware that there are two kinds of butterfly spread as well: the long butterfly spread and the short butterfly spread.

Long Butterfly Spreads

This strategy is used when the expectation is for a market with low volatility. Traders will buy one option at a low strike price and then sell two options at a middle strike price (this portion of the trade is the body of the butterfly). It is finished off with buying one option at a higher strike price, which becomes the butterfly’s wings.

The best profit scenario is when the price of the underlying is at or near the middle strike price, while the max loss is limited to the net cost of the spread.

Short Butterfly Spreads

Unlike the long spread, the short butterfly spread is best for situations where the expectation is high for increased market volatility. You execute the strategy by selling one option at a low strike, buying two options at a strike price that’s in between the high and low strike, and selling one option at a higher strike price.

Unlike the long butterfly, the short butterfly spread makes the most money when the underlying’s price moves away significantly from the middle strikes. The worst loss that a trader can incur with the short butterfly is the difference between the strike prices, minus the net credit they gain for setting up the trade.

Market Conditions That Favor Butterflies

When is it best to use the iron butterfly spread in your trading strategy? Below, we have outlined the ideal volatility profile for the broader market and when to deploy.

• Markets That Are Range Bound: The butterfly spread succeeds the best when the underlying asset is trading in a narrow range of prices or if the prices are expected to consolidate once more following a market shift.
• Low Volatility Setting: The butterfly spreads perform the best when the underlying’s price is not expected to make any big movements and is going to remain relatively stable. These spreads thrive in environments where there are few events pushing the prices upward or downward significantly and where time decay can play a big role.
• High Implied Volatility: Traders can collect a larger premium from the short option in the spread when implied volatility is high and push the value of the premium upward. It’s ironic considering that the strategy is largely based around low-volatility conditions.

Profit & Loss Potential

One of the best perks of the iron butterfly is the fact that it comes with limited risk and reward that are well-defined when you are initially setting up the new position. It is key to note, however, that the butterfly spread can offer a higher profit potential than the iron condor, though it can only happen in a much narrower range.

• Long Butterfly Profit Potential: This occurs when the asset’s price is exactly at the middle strike price when the expiration date hits. It can still deliver a strong profit even when the underlying price is right around or very close to the strike. To calculate this, you take the difference between the lower and middle strikes, minus the initial cost of the spread. Be sure to include commissions as well.
• Long Butterfly Loss Potential: The maximum loss for the long butterfly is limited to the initial price paid to enter the spread. This only occurs in the event that the underlying’s price falls below the lowest strike price or rises above the highest strike price by the time of the spread’s expiration date.
• Short Butterfly Profit Potential: Because the short butterfly is reliant on the underlying asset price moving significantly in either direction before the expiration date, trades simply get to keep the net credit received from creating the spread to begin with. As long as the market moves drastically, the trader can secure the largest profit potential for the spread.
• Short Butterfly Loss Potential: The max loss with the short butterfly is known at the beginning of the trade and is limited to the difference between the strike prices involved minus the premium that the trader gets in the beginning when they enter the position. This happens when the underlying’s price expires right at the strike price of the long options.

While the iron butterfly offers a higher overall profit for the trader compared to the iron condor, it should be noted that there is such a narrow range needed for max profitability, which means that the likelihood of it happening is slim.

Pros & Cons

Now let’s take a look at the main advantages and disadvantages you might run across when using an iron butterfly spread for dealing with a market that has a neutral outlook. Like the iron condor, this one tends to have more positives about it than negatives, but using it effectively ultimately depends on your risk tolerance and trading goals.

Pros

• Low Cost: Butterfly spreads are a combination of buying and selling options, which can offset some costs that are tied up in individual contracts. Compared to other trading strategies, the butterfly spreads are some of the more low-cost options, and a lot of it has to do with the income generation they feature, which can bring the operation overhead costs down significantly.
• Capital-Efficient: Iron butterflies require a relatively small upfront capital commitment compared to other options trading strategies that have extremely similar profiles in terms of risk and reward.

Cons

• Precision Required in Underlying Price Forecast: Traders need to have a high degree of confidence that the underlying price is going to remain within a narrow range of prices to maintain profitability.

Iron Condors vs. Butterfly Spreads—A Comparison

While both the iron condor and the iron butterfly can be used effectively to make money when the underlying asset is remaining within a certain range, these two strategies can be different in many ways, mostly notably for the fact that the butterfly spread offers a higher potential payout, but it is far less likely to happen than it would be to secure a smaller, but more steady profit from using the iron condor move. We have set up a comparison table to get you a good understanding of the strengths and weaknesses of these two strategies and what situations are appropriate for using each.

Iron Condor vs. Butterfly: Which Neutral Strategy is Better?

Adjustments & Exit Strategies

Neutral option strategies will require adjustments and exit strategies to deal with changes in the broader market. Even though they are mainly designed for range-bound markets where the prices stay within a certain range, neutral strategies like the iron condor or iron butterflies can greatly benefit from adjustments that can manage risk more effectively or maximize profits where needed. Below, we have outlined some of the most common ways to tweak these strategies and to plan an effective exit and secure more profit or limit some of the risks that could crop up.

• Adjusting Wings: This term refers to managing winners and losers in your portfolio. More specifically, it involves modifying the strikes for the out-of-the-money options within the spread, be it an iron condor trade or a move using a butterfly spread. Adjusting the wings can be done in an effort to reduce overall risk in the position or to increase the future profit potential.
• Early Exit Techniques in Volatile Conditions: Traders can use stop-loss orders, but have them execute automatically when a certain level of market volatility has been reached. They can use technical indicators such as the average true range as a basis for these orders to ensure that they get out of trade while the price is still rangebound.
• Rolling or Closing Spreads for Optimal Outcomes: If the spread is losing money, traders can choose to close it down early and take the loss before it gets any worse, or they could roll out the trade to a further expiration date to give the underlying’s price enough time to move profitably.

Case Study—Real Market Example

Check out our step-by-step setups of the iron condor and the butterfly spread to understand how you can set up these trades in your next session. As always, we encourage anyone reading to first use demo accounts or paper trading simulators to practice these moves before using real capital in a live market. These directions on setups can give you a better idea of how easy or difficult it might be to implement one of these moves.

Iron Condor on SPY

The goal with using an iron condor on the highly liquid EFT (SPY), which tracks the performance of the S&P 500, is to capture premiums if the SPY price stays within a defined range until the expiration date of the spread.

• Step 1: Choose an underlying asset from the S&P 500 as well as an expiration date that is set for either 30 or 45 days out. You could select any other date from in between, but that is the general range you’ll want to stick with. Choosing an underlying from the S&P 500 is ideal in this situation because these assets experience relatively stable price movements. The longer expiration date gives the trade space for time decay to work in your favor.
• Step 2: The iron condor consists of a bear call spread and a bear put spread, so the next step is to choose four strike prices total (two for each spread). For selling an OTM call on the bear call spread, choose a strike price that is above the current SPY price that you believe the price won’t reach by the expiration date. For buying a further OTM call on the bear call spread, choose a higher strike price that defines the upside maximum risk.

On the other hand, with the bull put spread, you’re selling an OTM put and buying a further OTM put, so the strike prices should be below the current SPY price that you believe the price won’t reach by expiration, and a lower strike price to define maximum risk on the downside, respectively.

• Step 3: The net credit is the maximum profit potential for the trade if everything goes according to plan. You can figure out this amount next. It’s the premium that you get from selling the two credit spreads. Of course, you must subtract the premium paid for buying the long options to arrive at the right amount.
• Step 4: The next step is to figure out your risk and reward scenarios for the iron condor. The maximum loss a trader can experience with this move is the difference between the short and long strikes on one side, minus the net credit the trader gets during the trade’s setup.
• Step 5: Place your order and then actively monitor the position. You can manage when necessary, like rolling out to a further expiration date or terminating the trade by taking the loss before the losses build up.

Butterfly Spread on QQQ

The QQQ is a popular EFT that tracks the performance of the NASDAQ 100 index, and setting up a butterfly spread is used when the trader is expecting QQQ to trade within a narrow range. Before setting up the trade, you should be looking at technical indicators, market events coming up, and historical volatility to confirm a neutral market outlook.

• Step 1: Choose the underlying asset you want to trade from the NASDAQ 100 index and then select an expiration date that is set for 30-45 days out to give time decay enough time to work to your benefit.
• Step 2: Next, you’ll want to choose your strike prices. For the short straddle or body of the iron butterfly, you will want to sell one ATM call option and one ATM put option at the same strike price. When it comes to the protective wings of the trade, you’ll want to buy an OTM call option with a higher strike price than the short call and buy one OTM put option with a lower strike price than the short put.
• Step 3: Now it is time to purchase the four legs that make up the butterfly spread. Make sure that the expiration date is the same between all four. Sell the ATM call and put options to form one half of the trade, and then buy the OTM call and put options to create the other half.
• Step 4: You’ll receive a premium from the initial setup. It comes from selling the ATM options minus the cost of buying the OTM options. This will be the max profit potential for the butterfly spread, so long as QQQ finishes at the strike price for the short option by the expiration date.
• Step 5: Keep an eye on the trade moving forward and make adjustments where needed. For instance, you’ll want to monitor time decay as this can help the butterfly spread to benefit. IV is another factor to keep an eye on—lower IV can benefit the spread by lowering the price of sold options.

Tools & Platforms for Strategy Execution

To succeed with a neutral market outlook strategy, traders will want to have the best broker platforms and trading tools at their disposal for getting the job done. Though it is ultimately up to you what you want to use, we have provided a few recommendations below that we feel will appeal to your trading plan.

Recommended Brokers

Check out the best broker apps and websites (at least in our opinion) for employing multi-leg options strategies such as iron condors or iron butterflies. We have included our full reviews of these platforms in the links below for your convenience.

• Interactive Brokers
• Firstrade
• Robinhood
• Tastytrade
• Charles Schwab

Though not every one of our suggestions might apply to your current needs, you can read the reviews to learn more about which platforms will be the best fit for your trading skill level, your current taste for risk, and need for continual education in the process.

Tools for Volatility Analysis

If you’re looking to get the best read on the market and how likely volatility will play a factor in how the options prices will be affected, we’d encourage you to implement some of the volatility analysis tools discussed below into your next trading sessions for better insights.

• IV Rank: Traders use this metric for volatility analysis to assess if the current IV of the asset is high or low compared to its historical averages.
• Probability Cones: These are visual tools used in options trading to signify the possible price range of an asset over a certain time that’s rooted in statistical probabilities and historical volatility.
• Standard Deviation: This volatility analysis tool quantifies how much a stock’s price will deviate from its average price over a certain period of time. Great volatility is signified by a higher standard deviation level.
• Bollinger Bands: Traders can use these bands to figure out which periods are characterized by high or low volatility. Volatility is usually lessening when the bands narrow, while volatility is likely increasing when the bands become wider.
• Cboe Volatility Index: Find out what the market’s expectation is for the future of volatility by using the VIX to hedge or speculate against volatility changes. It is a widely recognized indicator that is used all the time to get a gauge for what the future levels of volatility might be like.
• Keltner Channels: These channels are useful for finding the areas of the market that are going to experience the most volatility, so traders can spot possible price breakouts or reversals.
• Average True Range: Traders can use this volatility tool to get an idea of the extent of price range changes over a certain period of time. Average true range, or ATR, can be particularly helpful for gauging correct position size or setting up stop-loss levels.
• RVI (Relative Volatility Index): One of the lesser-used tools for volatility analysis, the relative volatility index is used by traders to measure the direction and intensity of the price volatility found in the given underlying asset.

Key Takeaways

Remember the following aspects of trading using neutral strategies as you go into your next trading session:

• Both Are Good for Neutral Markets: The iron condor and the iron butterflies are two strategies that can be used in neutral markets where the action is sideways. In other words, the prices for the underlying assets are remaining within a defined range and not falling below or rising above the range.
• Best Case Scenario for Iron Condor: Traders might consider using an iron condor when the underlying’s price is expected to stay within a wider range and the trader is looking for a higher probability of success for a lower profit.
• Best Case Scenario for Iron Butterfly: Traders should use the iron butterfly when the price is expected to stay within a super-narrow range and the trader is okay with a smaller probability of success in the pursuit of a higher overall profit.
• Iron Condors are Good for Beginners: The iron condor doesn’t require the trader to correctly predict the direction of the market, and adjustments can be easily made to accommodate market movements that go against the trader’s original plan.
• Iron Butterflies Are More Complex: It takes a lot more active management to get iron butterflies to a profitable place. The window for making them profitable more often than not is much more narrow than with the iron condor, so they aren’t as appealing to beginners.

FAQs

Find out what some of the most common questions are about the use of neutral strategies like the iron condor and the iron butterfly. We took the questions we got the most often from our customers and readers, answered them, and included them in the following section to get you some of the highlights on the subject.

Can I Use Iron Condors in High IV Markets?

Yes, traders can use the iron condor when the implied volatility levels in the market are high. Higher IV levels will push the price of premiums up, which works in favor of the trader because they can get a selling credit for simply selling the iron condor. This can lead to a much higher profit potential, so long as the price of the underlying remains rangebound until the expiration date.

What Happens to Butterflies on Expiration Day?

How the iron butterfly profits or loses the trader’s money largely depends on where the underlying’s price is relative to the strike prices that are used for each position that makes up the iron butterfly. If the price ends up outside the outer strikes, the trade will be considered a loss. If the price ends up within the middle strike price range, the trade can become profitable for the investor.

Are These Strategies Good for Beginners?

We would not generally recommend that newer traders begin with market-neutral strategies. While it seems like these trades would be good on paper for beginners due to the income generation factor and the fact that they can generate returns without having to correctly predict the direction of the market, they can be complex when it comes to proper execution, and traders have to have some skill and experience to successfully turn a profit in sideways or choppy conditions.

Final Thoughts

Neutral strategies can play a significant role in a volatile portfolio by helping the trader to manage risks and possibly earn more consistent returns. If you haven’t used them already, we would encourage you to use iron condors or butterfly spreads when the market is expecting prices to remain within a certain range for the foreseeable future.

To gain some familiarity with these strategies, join a reputable broker app and take advantage of any demo modes or paper trading simulators they might offer, so you can practice these moves without risking any of your capital right from the get-go. Encourage readers to paper trade and use tools before risking capital.