CHAPTER 14

Neutral Spread Trading

Most trading involves picking a direction for a stock or underlying market. A trader makes a decision that they believe a stock is going to move up in price and they take some sort of position to attempt to benefit from this rise in price. With option contracts a trader may actually profit from a position that anticipates a stock will not change much in price. The most common of these spreads are iron butterflies and iron condors.

Iron Butterfly

An iron butterfly is created through a combination of four different option contracts. All of these options share an expiration date and underlying security. Two of the options are calls and two of the options are puts. One long and one short position are taken in each of these contracts. Lower-priced call and put options are purchased while a call and put with higher premiums are sold. The net result is a trade that is done for a credit. With XYZ trading at 50.00 a basic example of an iron butterfly may be constructed in the following way:

Buy 1 XYZ 45 put at 0.25
Sell 1 XYZ 50 put at 1.70
Sell 1 XYZ 50 call at 1.75
Buy 1 XYZ 55 call at 0.30

The net income received from creating this trade would be 2.90 that results from taking in 3.45 from selling the 50 put and 50 call and then paying out 0.55 through purchasing the 45 put and 55 call. The best result for this trade would be XYZ closing at 50.00 at expiration. Table 14.1 demonstrates the payout for this spread if held to expiration.

Table 14.1

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