02/13/2014

No, not the 1970's heavy metal band (I really date myself here, don't I?). I mean one of my very favorite trading strategies. It is particularly useful when the market or a stock is range bound, or as now, going back and forth between rebounding and retracing. It is the Iron Butterfly (IB).

The IB can basically be seen as being short the straddle and long the straddle. Ideally, you want the entire trade to expire worthless right on the short strike. That makes the maximum profit the premium received and the maximum loss the difference between the strikes minus the premium received. Remember, all strikes must be equidistant. For the trade to be non-directional the short straddle should be at the money. Moving the straddle up or down slightly tweaks the directionality of the trade.

Let's take a real life example. Apple (AAPL) has been flying around and is now trading at 536. If we think the stock will stabilize at or around this level we can sell the March 535 straddle at 29.20 (15 in the call, 14.20 in the put) and buy the 500/570 strangle at 6.80 (3.50 in the 500 put and 3.30 in the 570 call). This gives us a maximum profit of 22.40, or $2240 per IB if we expire at 535 and a maximum loss of 5.80, or $580 per IB if we expire under 500 or over 570 for a nice 1:5 risk reward ration. And we have two break even points, 505.80 and 564.20.

Take the market as whole using the SPY (S&P 500 ETF). With SPY at 181 we can sell the March 180 straddle for 6.30 and buy the 175/185 strangle for 2.50. At 180 we make 3.80 and under 175 or over 185 we lose 1.20 with break evens at 176.20 and 183.80. We can see that both these trades are hedged with good risk reward ratios.

Don't try and duplicate these exactly as they are time and price specific. Once again, this is a way to help think about how to trade a market that you think will settle down or bounce around in a trading range.

Randall Liss, The Liss Report