Comparing Iron Condor, Ratio Spread and Broken-Wing Butterfly

Erin asked:

Hi Mark,

I was wondering if you had an opinion on ratio spreads and BWBs? Would
something like a 1:2 put ratio + 1:2 call ratio have any advantage over an IC, particularly with regards to adjustments?

Look forward to hearing your thoughts.

I'm guessing that BWB refers to a broken-wing butterfly (if not, I'm stumped).

The positions:

IC:                        + 10 GOOG Jul 380 put
                               – 10 GOOG Jul 390 put

                           -10 GOOG Jul 440 call
                    +10 GOOG Jul 450 call

Ratio:            -20 GOOG Jul 380 put     (IC is long this option)
                     +10 GOOG Jul 390 put    (IC is short this option)

                     +10 GOOG Jul 440 call
                    – 20 GOOG Jul 450 call

BWB               +10 GOOG Jul 440 call
                      -20 GOOG Jul 450 call
                      +10 GOOG Jul 470 call

These positions are very different.  For example when comparing the iron condor with the ratio spreads, they are long and short the opposite options.

For our discussion, let's assume by 'time to make an adjustment' you are suggesting that the market has moved higher the short call is threatening to move into the money.  It doesn't matter how far OTM that call currently is, because different investors have different points at which they adjust.

Let's also assume that the short option is 10 points farther OTM than the long option.

The last assumption is that the adjustment of choice is to exit the position.


Iron Condor

With an IC, you are short a call spread that can become worth $1,000 (worst case); and you sold it for far less.  Our responsibility as risk manager, is to prevent that (or any similar loss) from happening.

The danger occurs as GOOG approaches 440.  If holding or closing the trade is the only consideration, I recommend establishing a maximum acceptable loss, and if and when that point is reached, exit.  That may when the call spread reaches $4, or $5, or whichever price your comfort zone allows. [Remember that if you bought the IC and collected $3 originally, then paying $5 is not the disaster it would be if you collected only $1.]  Your decision is when to pull the trigger.

Ratio Spread

With a ratio spread, you face a far different situation.  This time you own the 440s and are short twice as many 450s. 

There's the good news:  You own a spread that is ITM and is heading towards the point where it will reach maximum value of $1,000 (if it remains there at expiration).  So that's a better situation than you faced with the iron condor. 

But, you are short two calls instead of only one, and the second is a naked short. Some brokers do not allow customers to carry naked short call positions.  But, if you are allowed to do so, it's considered to be a risky trade and I no longer allow myself to own such positions, but that's not the point of this discussion.

Once GOOG moves past 450, then the naked short option quickly eliminates any profit you had from the 440/450 call spread [Mentally breaking this trade into two parts: the call spread and the naked short].  In fact, if there is much time remaining before the options expire, the position quickly turns into a  loser, with the loss mounting as the stock rises. 

When there's very little time remaining, the position still has terrible negative gamma, but the limited time prevents the extra 450 call from exploding.  If time runs out (the market closes on expiration Friday), and if GOOG is under 460 (your break-even point if you paid zero cash to establish the position), things are not too bad.  Obviously, a lower price is better.

The major factor in deciding whether to hold or exit is going to be time.  With expiration rapidly approaching, you may still want to exit because you probably have a profit (although it's only risk that should matter, but I know that most traders only want to know if they have a profit or loss, and risk be damned.  This is not good thinking, but it is the way the world turns).

Thus, it's possible to have a good profit as the stock moves towards 450, and that profit possibility makes this trade look 'better' than the iron condor – which has v
irtually no chance of being profitable as GOOG moves towards 440 – a full 10 points lower!

The ratio has a higher profit range, but there is that 'unlimited loss' possibility that makes it more dangerous to own.  In response to your question Erin, I'd rather have the adjustment decision with this position than with the iron condor.

This is just another personal comfort zone decision.  The optimist  understands that the stock is currently at its sweet spot, but danger looms.  The intelligent pessimist sees the danger, and may fold in the name of safety.

These are interesting positions to own, but I have removed them from my arsenal of strategies – just because I do not want to face a margin call (which can happen as the stock rises) or a nightmarish stock market opening gap.

Broken-Wing Butterfly

With a BWB, you are short a 20-point spread, and the maximum loss is $1,000 less the premium collected to open the trade.

This is essentially the same as the ratio spread, but this time you are not naked short any options.  You own the 470 call and there is neither a potential margin call nor an unlimited loss in your future.

I'd treat this spread the same as the ratio spread because it is the ratio spread.


I hope that helps.  The iron condor is really the odd man out.  The other spreads are similar to each other and the IC trades very differently. 

IMHO, the ratio (better yet the BWB) is easier to adjust because time is THE consideration.  [ADDENDUM: But the risk of owning such a position is so great, that I never recommend this position to anyone.]

Iron condors are risky at all times (if the short strike is approached) – but the risk is limited.


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