Equity and Index Options Explained

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The Iron Butterfly

No one should be intimidated by the colourful names of option strategies such as the “iron ’fly”. Traders have, over the years, given names to various popular strategies, the names often relating to the shape of the expiry payoff graphs of the strategies. Hence, names such as “butterfly” and “condor”. These strategies also have “bodies” and “wings”, another reason for the choice of names.

When selling options in practice, it is likely that the primary driver behind the trade will be the option prices themselves and/or a view that the market will become calmer. Specifically, our starting point is likely to be a view that options are too expensive because we believe that market volatility is currently unjustifiably high. As a result, we know that we want to be short of options. Our exact choice of which options to short will depend upon our view on the underlying market. Let's consider an example of how the decision-making process might work.

We are speculators in BP options. We believe that all BP options are currently overpriced. As ever, this view may be intuitive, a result of familiarity with BP option prices or the result of a more technical approach involving the study of implied “vols”. Either way, our starting point is a view that BP options are currently too expensive. We therefore want to sell them. We want to sell BP options but which ones? This is the point at which our underlying view comes into play.

Simply, if we are bearish (or at the very least ...