the  maximum  proﬁt  of  $320  per  contract,  or$1,600, would be achieved from an initial $900 investment.
Notice how the risk graph in Figure 10.2 shows the trade’s limited re-ward  and  limited  risk.  The  risk  graph  also  points  out  that  the  maximumproﬁt is impossible to achieve until expiration. This strategy rarely sees atrader get out with a proﬁt at the beginning of the trade. This is because abutterﬂy beneﬁts from time erosion. We normally would like to see at leasta 2-to-1 reward-to-risk ratio when trading a butterﬂy. For this trade, ourreward-to-risk ratio was about 1.8 to 1, but we could have easily gotten a 2-to-1 ratio by getting a price somewhere between the bid and the ask.
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FIGURE 10.2 Risk Graph of Long Butterﬂy on IBM (Source: OptioneticsPlatinum © 2004)
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Long Butterﬂy Case Study
Strategy: With  the  security  trading  at  $89.28  a  share  on  October  16,2003,  go  long  5  November  85  calls  @  5.20,  go  short  10  November  90calls @ 2, and go long 5 November 95 calls @ 0.60 on IBM.
Market Opportunity: Expect stock to stay in narrow range through No-vember expiration.
Maximum  Risk: Limited  to  the  net  debit.  In  this  case,  the  max  risk  is$900: [(5.20 + .60) – (2 + 2)] × 5 × 100.
Maximum Proﬁt: Limited to difference in strikes less initial debit. In thiscase, $1,600: [(95 – 90) – 1.80] × 100 = 320; (320 × 5).
Downside Breakeven: Lower strike plus the initial cost per contract. Inthis case, 86.80: (85 + 1.80).
Upside  Breakeven: Upper  strike  minus  the  initial  cost  per  contract.  Inthis case, 93.20: (95 – 1.80).
IBM shares did indeed trade sideways through November expiration,closing  at  $88.63  on  November  21.  This  left  the  trade  with  a  proﬁt  of$180—a 100 percent return—which is calculated by taking the value of thelong option ($180) and subtracting any options that had to be purchased.However, no additional options had to be purchased because the 90 op-tions were out-of-the-money at expiration.
LONG CONDOR
Like the butterﬂy, a condor is composed of a body and wings. In the caseof the long condor, the wings are composed of two long options—one in-the-money and one out-of-the-money. The body includes two short inneror middle options. Again, this type of strategy works well when the strate-gist expects the stock or market to remain range-bound.
Most  often,  the  long  condor  is  constructed  using  four  strike  prices.For example, a strategist might buy one in-the-money call, sell two callswith different strike prices (one at-the-money and one out-of-the-money),and buy one deeply out-of-the-money. Since this trade involves four sepa-rate options contracts, managing commissions is an important aspect ofthis trade—the lower the commissions, the better.
The goal of the long condor is to see the short options expire worth-less,  but  also  see  the  in-the-money  option  retain  most  of  its  value.  Themaximum  potential  reward  is  calculated  by  subtracting  the  net  debit  ofthe trade from the difference between the strike prices. If the underlying
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security makes a dramatic move higher or lower, the long condor gener-ally yields poor results. The upside breakeven is equal to the highest strikeprice  minus  the  debit.  The  downside  breakeven  is  equal  to  the  loweststrike prices plus the debit. The maximum risk associated with this tradeis limited to the net debit.
Long Condor Mechanics
In  order  to  see  how  the  long  condor  works,  let’s  say  XYZ  is  trading  for$66.40  a  share  on  May  10.  We  expect  the  stock  to  stay  within  a  tradingrange of $65 and $70 a share for the next several months. Consequently, along condor is examined using October call options.
To create the trade, we ﬁrst go long one October XYZ 60 call at $8 andlong one October XYZ 75 call at $1. Next, we go short the October XYZ 65call at $5 and short the October XYZ 70 call for $2. The net debit on thistrade  is  $200,  which  is  also  the  maximum  risk.  The  maximum  reward  isequal to the difference between the strike prices minus the debit, or $300per contract: [(75 – 70) – 2] × 100 = $300. The upside breakeven equals thehighest strike prices minus the net debit, or 73 (75 – 2 = 73). The downsidebreakeven is computed as the lowest strike price plus the net debit, or 62(60 + 2 = 62). The risk graph of this trade is shown in Figure 10.3.
Ideally,  with  this  trade,  the  strategist  will  see  the  short  options  losevalue, but the deeply-in-the-money call will retain its value. For instance, ifthe stock price is equal to $65 a share at expiration, the only option withany remaining intrinsic value will be the October 65 call. In that case, threeof the options expire worthless, but the October 60 call is worth $5. TheOctober 60 can then be exercised or closed. If so, the net proﬁt from thetrade will be the proﬁt earned from the October 60 call minus the debit.
Exiting the Position
Exit strategies for the condor are similar to the butterﬂy spreads.
• XYZ falls below the lower breakeven (62): This is the maximumrisk  range  for  this  trade.  The  strategist  will  probably  let  the  optionsexpire worthless and incur the maximum risk. Make sure to salvageany remaining value of the October 60 call if the stock price is below$62, but above the October 60 strike price at expiration.
• XYZ  remains  between  the  downside  (62)  and  upside  (73)breakevens: Ideally, the stock price will fall near the strike price of theﬁrst short option at expiration. Let the out-of-the-money options expireworthless and close the positions involving the in-the-money-options.• XYZ  rises  above  higher  breakeven  (73): Close  the  position  to
avoid assignment and incur the maximum risk.
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FIGURE 10.3 Long Condor Risk Graph
Long Condor
Strategy: Buy lower strike option, sell higher strike option, sell an evenhigher strike option, and buy and even higher strike option with the sameexpiration date (all calls or all puts).
Market Opportunity: Look for a range-bound market that is expected tostay between the breakeven points for an extended period of time.
Maximum  Risk: Limited  to  the  net  debit  paid.  (Long  premiums  –  shortpremiums) × 100.
Maximum Proﬁt: Limited. (Difference between strike prices – net debit)× 100. The proﬁt range occurs between the breakevens.
Upside Breakeven: Highest strike price – net debit.
Downside Breakeven: Lowest strike price + net debit.
Margin: Subject to brokerage ﬁrm policy. Could be treated as a bull callspread and a bear call spread.
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Long Condor Case Study
A condor is similar to a butterﬂy, but this strategy widens out the maxi-mum reward. A condor is still a sideways trading strategy that takes ad-vantage of time erosion. Choosing between a condor and a butterﬂy has todo with the range the stock is expected to trade and the risk graph. Re-member, a butterﬂy has a maximum proﬁt at a speciﬁc price. A condor hasa maximum proﬁt across a range of prices.
A  condor  is  a  limited  risk,  limited  reward  strategy.  The  initial  entryinto  a  condor  creates  a  net  debit,  which  is  also  the  maximum  risk.  Themaximum reward is the difference between strikes less the initial debit.For  example,  if  we  enter  a  30-35-40-45  condor,  we  would  buy  a  30  put(call), sell a 35 put (call), sell a 40 put (call) and buy a 45 put (call). If ourinitial  debit  were  $2,  our  maximum  risk  would  be  $200.  The  maximumproﬁt  occurs  if  the  underlying  security  closes  between  the  two  soldstrikes  at  expiration.  This  is  the  main  attraction  of  a  condor,  as  it  has  alarger  maximum  proﬁt  zone  than  a  regular  butterﬂy.  However,  the  riskalso increases with the added reward.
As  in  the  long  butterﬂy  case  study,  in  mid-October  2003,  a  tradermight have looked at IBM and expected it to trade sideways through No-vember’s  option  expiration  on  the  21st.  On  October  16,  IBM  closed  at$89.28 and it seemed likely that the stock would consolidate near $90 aftera signiﬁcant decline. As a result, we could have entered a condor using the80-85-90-95 put options. All calls could also be used, with the best reward-to-risk ratio being the one that should be used. Since we beneﬁt from timeerosion  and  because  we  don’t  want  to  give  the  stock  too  much  time  tomove out of its range, it’s normally best to use front month options whentrading a condor.
The November 80 puts could be purchased for $0.30, with the 85 putsselling for $0.90. The 90 puts could be sold for $2.80, with the 95 puts cost-ing $6.50. This created a debit of $3.10 per contract, with ﬁve contracts fora total of $1,550, which is also the maximum risk. The maximum reward iscalculated  by  subtracting  the  net  debit  from  the  difference  in  strikes  (5points). In this trade, if IBM were to close anywhere between $85 and $90on  expiration,  the  maximum  proﬁt  of  $190  [(5  –  3.10)  × 100  =  $190]  percontract, or $950 (5 × 190 = $950), could be kept. The breakeven pointswere at 83.10 and 91.90 and are found by taking the net debit of $3.10 andadding  it  to  the  lower  strike  for  the  downside  breakeven:  (80  +  3.10  =83.10). The upside breakeven is found by subtracting the $3.10 debit fromthe higher option strike: (95 – 3.10 = 91.90).
Notice how the risk graph (see Figure 10.4) shows the trade’s limitedreward and limited risk. The risk graph also points out that the maximumproﬁt is impossible to achieve until expiration. This strategy rarely sees a
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FIGURE 10.4 Risk Graph of Long Condor on IBM (Source: Optionetics Platinum © 2004)
trader get out with a proﬁt at the beginning of the trade. This is becausea  condor  beneﬁts  from  time  erosion.  We  aren’t  going  to  see  as  high  a reward-to-risk ratio trading a condor as trading a butterﬂy, but our max-imum  proﬁt  is  more  likely  to  be  achieved  because  of  the  wider  maxi-mum proﬁt range.
IBM shares did indeed trade sideways through November expiration,closing at $88.63 on November 21. This left this trade with the maximumproﬁt of $950. If the stock had closed above 95 or below 80, the maximumloss would have occurred.
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Long Condor Case Study
Strategy: With  the  security  trading  at  $89.28  a  share  on  October  16,2003, go long 5 November IBM 80 puts @ .30, go short 5 November IBM85 puts @ .90, go short 5 November IBM 90 puts @ 2.80, and go long 5November IBM 95 puts @ 6.50.
Market Opportunity: Expect stock to stay in narrow range through No-vember expiration.
Maximum  Risk: Limited  to  the  net  debit.  In  this  case,  the  max  risk  is$1,550: [(6.50 + .30) – (.90 + 2.80)] = 3.10; (3.10 × 5) × 100.Maximum Proﬁt: Limited. (Difference in strikes – the net debit) × 100. Inthis case, the max reward is $950: [(85 – 80) – 3.10] × 5 × 100.
Downside Breakeven: Lower strike plus the net debit. In this case, theDB is 83.10: (80 + 3.10).
Upside  Breakeven: Higher  strike  minus  the  net  debit.  In  this  case,  theUB is 91.90: (95 – 3.10).
Margin: None.
LONG IRON BUTTERFLY
The long iron butterﬂy is another strategy that works well in range-boundmarkets.  It’s  actually  a  combination  of  a  bear  call  spread,  with  (a  shortATM call and a long OTM call), along with a bull put spread (a long OTMput and a short ATM put). The short put can have a lower strike price thanthe short call. Therefore, unlike the long butterﬂy with only puts or onlycalls, the iron butterﬂy includes both puts and calls, as well as four differ-ent options contracts instead of three.
To structure the trade, the strategist will buy an OTM call and an OTMput. At the same time, they will sell an ATM call. In general, the short callwill have a strike price in the middle of the stock’s recent trading range.Finally,  an  ATM  or  slightly  OTM  put  is  also  sold.  In  contrast  to  the  longbutterﬂy, which is established for a debit, the iron butterﬂy is done for acredit because the strategist is buying two out-of-the-money options andselling two at-the-money options.
Both the risks and the rewards of the long iron butterﬂy are limited.The success of the trade depends on the stock staying in between the up-side and downside breakevens. The upside breakeven is computed as thestrike price of the short call plus the net credit received for the trade. Thedownside breakeven is equal to the short put strike price minus the net
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credit. The maximum reward is the total credit received on the trade. Thegreatest risk is equal to the difference between the strike prices minus thenet credit. Also, importantly, since this trade involves four contracts, thecommissions  can  be  signiﬁcant.  For  that  reason,  although  the  risks  aregenerally  limited,  keeping  commissions  low  will  greatly  improve  the  re-ward potential of the iron butterﬂy trade.
Long Iron Butterﬂy Mechanics
Let’s  say  you’ve  been  watching  XYZ  Corporation  and  believe  the  com-pany’s  share  price  will  stay  in  a  range  for  the  next  several  months.  Thestock is currently trading for $70.75 a share. Consequently, in the month ofMay, you decide to create a long iron butterﬂy by going long one OctoberXYZ 75 call at $2.50 and going short one October XYZ 70 call at $5, whichis the bear call spread of the trade. At the same time, you go long one Oc-tober XYZ 60 put at $1 and go short one October XYZ 65 put at $2—thebull put spread side of the trade. All told, the sale from the short optionsequals $7 and the cost of the long options is $3.50. So, this trade fetches anet credit of $3.50, or $350 per spread.
The maximum proﬁt from the long iron butterﬂy is equal to the creditand will occur if the stock is between the strike prices of the two short op-tions at expiration. If so, all the options expire worthless and the strategistwill keep the premium earned from both the bull put spread and the bearcall spread. In this example, the maximum proﬁt is $350. The risk graph ofthis trade is shown in Figure 10.5.
Ultimately,  the  strategist  wants  the  stock  to  trade  sideways.  If  XYZmakes a dramatic move higher or lower, above or below the breakevens,the  long  iron  butterﬂy  will  probably  result  in  a  loss.  To  compute  thedownside breakeven, subtract the net credit from the strike price of theshort put, or 61.50: (65 – 3.50 = 61.50). The upside breakeven equals theshort call strike price plus the net credit or, in this example, 73.50: (70 +3.50  =  73.50).  A  move  above  or  below  the  breakeven  can  result  in  themaximum  possible  risk,  which  is  equal  to  the  difference  between  thestrike prices minus the net credit. In this case, the maximum risk is $150per spread: (5 – 3.50) × 100.
Exiting the Position
In  the  case  of  the  iron  butterﬂy,  the  strategist  wants  the  underlyingstock to remain between the two breakevens at expiration. Moreover, ifthe stock falls between the two strike prices of the short options, all of
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FIGURE 10.5 Long Iron Butterﬂy Risk Graph
Long Iron Butterﬂy
Strategy: Buy  a  higher  strike  call,  sell  a  lower  strike  call,  sell  a  higherstrike put, and buy a lower strike put all with the same expiration date.
Market Opportunity: Look for a range-bound market that is expected toremain quiet until expiration.Maximum Risk: (Difference in strike prices × 100) – net credit received.Maximum  Proﬁt: Net  credit.  (Short  premiums  –  long  premiums)  × 100.The proﬁt range occurs between the breakevens.
Upside Breakeven: Strike price of middle short call + net credit.
Downside Breakeven: Strike price of middle short put – net credit.
Margin: Check with broker. Some brokerage ﬁrms treat the long iron but-terﬂy  as  a  short  straddle  and  a  long  strangle.  If  so,  the  margin  require-ments  can  be  signiﬁcant.  Look  for  a  broker  that  treats  them  as  acombination of a bull put spread and a bear call spread.
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the options expire worthless and the trade yields the maximum proﬁt—the net credit.
• XYZ falls below the lower breakeven (61.50): Let the call optionsexpire worthless. Exit the bull put spread in order to avoid assignment.• XYZ  remains  between  the  downside  (61.50)  and  upside(73.50)  breakevens: Ideally,  the  stock  price  will  land  between  thestrike prices of the short options at expiration. Let the options expireworthless and keep the credit.
• XYZ rises above higher breakeven (73.50): Let the put options ex-pire worthless. Exit the bear call spread in order to avoid assignment.
Long Iron Butterﬂy Case Study
A long iron butterﬂy is a strategy best used when a trader expects side-ways  movement  in  a  stock  or  index.  A  long  iron  butterﬂy  has  the  samerisk graph as a condor, but is composed of a bull put spread and a bearcall  spread.  This  strategy  combination  creates  a  net  credit  instead  of  adebit. However, the same risks and rewards as a condor are present. Sometraders call this a long iron condor, which has the same characteristics.
Let’s review: An iron butterﬂy is a limited risk, limited reward strat-egy. The initial entry into an iron butterﬂy creates a net credit, which is themaximum  reward.  The  maximum  risk  is  the  difference  between  strikesless the initial credit. For example, if we enter a 30-35-40-45 iron butterﬂy,we would buy a 30 put, sell a 35 put, sell a 40 call, and buy a 45 call. If ourinitial credit were $300, our maximum risk would be $200. The maximumproﬁt  occurs  if  the  underlying  security  closes  between  the  two  soldstrikes at expiration. This is the main attraction of an iron butterﬂy, as ithas a larger maximum proﬁt zone than a regular butterﬂy. However, therisk also increases with the added reward.
As  in  the  previous  two  case  studies,  in  mid-October  2003,  a  tradermight have looked at IBM and expected it to trade sideways through No-vember’s  option  expiration  on  the  21st.  On  October  16,  IBM  closed  at$89.28 and it seemed likely that the stock would consolidate near $90 aftera signiﬁcant decline. As a result, we could have entered an iron butterﬂyusing the 80-85-90-95 put and call options. Since a long iron butterﬂy bene-ﬁts from time erosion and we don’t want to give the stock too much timeto move out of its range, it’s normally best to use front month options.
The November 80 puts could be purchased for $0.35, with the 85 putsselling for $0.95. The 90 calls could be sold for $2, with the 95 calls cost-ing  $0.60  creating  a  net  credit  of  $200  per  contract:  (.95  +  2.00)  – (.35  +  .60)  × 100.  Thus,  a  total  of  ﬁve  contracts  bring  in  a  net  credit  of
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$1,000, which is also the maximum reward. The maximum risk is calcu-lated by subtracting the net credit ($200) from the difference in strikes (95– 90 = 5). This creates a maximum risk of $300: (5 – 2) × 100 = $300. If IBMwere to close anywhere between $85 and $90 on expiration, the maximumproﬁt of $200 per contract, or $1,000 (for ﬁve contracts), could be kept.The breakeven points were at $83 and $92 and are found by taking the netcredit  of  $2  and  subtracting  it  from  the  lower  sold  strike  for  the  lowerbreakeven. The upper breakeven is found by adding the $2 credit to thehigher sold option strike.
Notice  how  the  risk  graph  (see  Figure  10.6)  shows  limited  rewardand limited risk. The risk graph also points out that the maximum proﬁtis  impossible  to  achieve  until  expiration.  This  strategy  rarely  sees  a
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FIGURE 10.6 Risk Graph of Long Iron Butterﬂy on IBM (Source: OptioneticsPlatinum © 2004)
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Long Iron Butterﬂy Case Study
Strategy: With  the  security  trading  at  $89.28  a  share  on  October  16,2003,  Long  5  November  IBM  80  Puts  @  0.35,  Short  5  November  IBM  85Puts @ 0.95, Short 5 November IBM 90 Calls @ 2, and Long 5 NovemberIBM 95 Calls @ 0.60.
Market  Opportunity: Expect  stock  to  stay  in  narrow  range  throughNovember expiration.Maximum Proﬁt: Limited to the net credit. In this case, $1,000: {5 × [(.95+ 2.00) – (.35 + .60)]} × 100.
Maximum Risk: Limited to difference in strikes minus the net credit. Inthis case, $1,500: 5 × [(5 – 2) × 100].
Lower Breakeven: Lower short strike minus the net credit. In this case,83: (85 – 2).
Upper  Breakeven: Higher  short  strike  plus  the  net  credit.  In  this  case,92: (90 + 2).
Margin: Minimal—just enough to cover the broker’s risk.
trader get out with a proﬁt at the beginning of the trade. This is becausean  iron  butterﬂy  beneﬁts  from  time  erosion.  We  aren’t  going  to  see  ashigh a reward-to-risk ratio trading an iron butterﬂy, but our maximumproﬁt  is  more  likely  to  be  achieved  because  of  the  wider  maximumproﬁt range.
IBM shares did indeed trade sideways through November expiration,closing at $88.63 on November 21. This left this trade with the maximumproﬁt of $1,000. If the stock had closed above 95 or below 80, the maxi-mum loss would have occurred.
CALENDAR SPREAD
A calendar spread is a trade that can be used when the trader expects agradual or sideways move in the stock. Sometimes called the horizontalspread, it uses two options with the same strike prices and different expi-ration dates. It can be created with puts or calls. Generally, with the cal-endar  spread,  the  option  strategist  is  buying  a  longer-term  option  andselling  a  shorter-term  option.  Unlike  the  vertical  spreads  like  bull  callspreads, bear put spreads, and other trades that are directional in nature(i.e., they require the shares to move higher or lower), calendar spreads
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