Managing Iron Condor Using Butterfly Spreads

In this video we would be looking at some possible adjustments that can be made to a troubled Iron Condor position using two different Butterfly spreads.

But before that, let's learn about two of the four primary Greeks - Delta and Gamma.

Option Greeks - Delta & Gamma

Delta is defined as the change in the option premium for a unit change in the underlying asset.

Delta of a Call option is always positive (between 0 and 1). The delta of an ATM Call option is close to 0.5. Delta moves to 1 as the Call goes deep ITM. It moves to zero as the Call goes deep OTM.

Conversely, Delta of a Put option is always negative (between -1 and 0). The delta of an ATM Put option is close to -0.5. Delta moves to -1 as the Put goes deep ITM. It moves to zero as the Put goes deep OTM.

As the price of the underlying asset price increases, you would expect call option prices to rise and put option prices to fall.

Example:

A delta of 0.6 means the price of the option is expected to increase by ₹0.6 for a ₹1 increase in the underlying asset price.

A delta of -0.4 means the price of the option is expected to decrease by ₹0.4 for a ₹1 increase in the underlying asset price.

Say, Nifty is at 9900 and the ATM 9900 call option premium is 247. So, if Nifty moves to 10000, the 9900 call option premium would theoretically go up by 50 (0.5 x 100). It’s value would now be 297. But there are several other factors that influence the pricing of an option, one of them being Gamma.

Delta can be used as an estimate for the probability of an option expiring in the money. So, an option with a delta of 0.2 has a 20% probability of expiring in the money.

Gamma:

Gamma measures the rate of change in an option’s Delta per ₹1 change in the price of the underlying asset.

Gamma is the highest when the option is ATM and decreases in both directions as the underlying moves away from the strike price. Options with the highest gamma are the most sensitive to changes in the price of the underlying asset. And hence ATM options are the most sensitive to underlying price changes.

Say, Nifty is at 9900 and the ATM 9900 call option premium is 247. The delta of the 9900 call option is 0.5 and the gamma is 0.0006. So, if Nifty moves to 10000, the 9900 call option premium would theoretically go up by 54.5 (0.5 x 100 + 0.0006 x 75 x 100). It’s value would now be 301.5.

As learned in the previous videos, an iron condor is a combination of two credit spreads - a bull put spread and a bear call spread.

Credit spreads possess negative gamma and since an Iron Condor is made up of two credit spreads it possesses negative gamma too. That is, the position loses value as the price of the underlying approaches one of the short strike prices.

So in order to hedge the negative gamma, we need to add positive gamma options positions such as debit spreads and butterfly spreads close to the short strike prices. In a previous video we learned how to use a Bull Call spread, a debit spread, to manage a troubled Iron Condor.

Now let’s see how we can use butterfly spreads to adjust the tested side of an Iron Condor.

Now let’s look at a sample Iron Condor trade:

Nifty is at 9950 on June 2, 2020. An Iron Condor position can then be entered as follows:

Buy three 25 June 8900 strike price Puts at 44.95
Sell three 25 June 9200 strike price Puts at 78.34
Sell three 25 June 10500 strike price Calls at 64.25
Buy three 25 June 10800 strike price Calls at 28.35

Say, three weeks into the trade, Nifty moved down to 9500, which is about 3% above the strike price of the sold Put of the IC. This should be our first trigger. An adjustment to the sample trade can then be made by adding a Butterfly spread as follows:

Buy one 25 June 9500 strike price Put at the prevailing market price
Sell two 25 June 9400 strike price Puts at the prevailing market price
Buy one 25 June 9300 strike price Put at the prevailing market price


Please note that it should be a balanced butterfly spread. That is, the strikes for the two wings are equidistant from the middle strike. It should be placed just above the strike price of the short Put of the original Iron Condor position. This adjustment should be considered only when there is about 1-2 weeks left to expiry and not before that.

A similar adjustment can be made to the Call side of the Iron Condor if Nifty moved to the upside.

The risk graph of the Iron Condor with the Butterfly spread added would then look like this.

It is clear that this adjustment has removed some risk on the Put side but since this is an adjustment done for a debit there is some sacrifice on the reward side too but if the price of the underlying ends exactly at the middle strike of the butterfly spread we get to make more profit than the original iron condor.

Similar results can be achieved by using a Christmas Tree Butterfly spread w/ Puts in place of the long Put butterfly spread.