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 this 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.
Short Straddle:
- A short straddle is a combination of selling an at the money call option and selling an 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.
- Example: 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 straddle strikes. This creates a profitable 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, in addition to selling the at the money strikes similar to the short straddle we just discussed, you buy outside wings to define your risk and create protection.
- 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.
- Example: 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.
Pricing 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.
- Example: In straddle A, you put up $2,000 in margin 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 in margin, but you are able to collect a $500 credit. This is 5% of return per unit of risk. Straddle B provides a higher ROI (premium per unit or 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.
Pricing Example: EFA - Emerging Market ETF
- Let’s look at real pricing on an EFA iron butterfly to examine the skew between calls and puts that sometimes happens.
- 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 limit your risk to $500 for $1 in premium.
- 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 costs 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 nearly as efficient as when we went from $66 to $65.
- Therefore, the best option is to buy the $65 call options. So, be flexible when you build out these iron butterflies to see what strikes give you the best ROI.
- A 10 Delta on either end is a great starting point to start this analysis. I usually like to pay $10-15 for the outside wing contracts.
Trade-Offs: Straddle vs. Iron Butterfly
- Now, let’s go over some of the research we learned from the Profit Matrix report.
- Short straddles make more money than short iron butterflies.
- Looking at the top 10 strategy variations 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 strategy had a 51% drawdown at some point during the back-test.
- The top iron butterfly strategy 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 because it's pure options selling, so you have shorter durations in the trades.
- The top short straddle won 70.22% of the time.
- The top iron butterfly won at 66.8% of the time.
General Rules: 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.
- Because, during a period of low IV environment, there can be a spike in IV at any time, which can create a huge risk of margin expansion.
- Therefore, the iron butterfly will help to protect against this potential risk.
