What Is Iron Butterfly Options?
The Iron Butterfly is an options trading strategy that requires buying and holding four different options contracts at three distinct strike prices. it is also known as the Ironfly options trading strategy. The Iron butterfly options trading strategy is also a non-directional options strategy.
Iron butterfly options is a limited-risk, limited-profit options trading strategy which is built for a higher probability of earning, but a smaller and limited profit when the underlying stock is known to have lower volatility. This strategy is usually suitable when the market behaves sideways or with a mild upward or downward trend.
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Construction of Iron Butterfly Options Strategy
Options trader can create an iron butterfly options strategy by following these steps:
- Buy one out-of-the-money put option with a strike price below the current market price of the stock. This will protect against a fall in the stock price.
- Sell one at-the-money put option with a strike price near the current market price of the stock.
- Buy one out-of-the-money call option with a strike price above the current market price of the stock. The out-of-the-money call option will defend against a high surge in stock price.
- Sell one at-the-money call option with a strike price above the current market price of the stock.
Understanding The Iron Butterfly Options Strategy
One can conceive of this strategy as concurrently running a ‘Bear Call Spread’ and ‘Bull Put Spread’. The spread consists of two call options and two put options at three different strike prices and all strike prices should have the same expiration date. A call option and a put option both sold at a middle strike price to form the body of a butterfly and a call option and put option is purchased above and below the strike price to form the wing.
The strike prices for the options contracts sold should be sufficient enough to account for a range of movements in the underlying security. This will enable the investor to be able to forecast a range of price movement as opposed to a small range near the target price.
The strategy earns the maximum profit when the underlying security closes precisely on the middle strike price at expiry where the call and put options are sold. A trader will create an Iron Butterfly trade by following the above steps.
The Iron Butterfly options strategy is basically a subset of the Iron Condor options strategy using the identical strike for the short options. The goal of this strategy is to make a profit from conditions where the price remains somewhat stable and the options showing the decline in implied volatility and historical volatility.
Iron Butterfly Options Strategy Profit And Loss
- Maximum Profit = Net Premium Received – Commissions Paid
The maximum profit for the iron butterfly options strategy is achieved when the underlying security price during the expiration is equal to the strike price at which the call option and put option are sold. At that price, the call and put options will expire worthlessly and the options trader will keep the net credit received while entering the trade as profit.
- Maximum Loss = Strike Price of Long Call – Strike Price of Short Call Option – Net Premium Received + Commissions Paid
The maximum loss for the iron butterfly strategy is limited and it occurs when the underlying security price falls below the lower strike of the long put option or rise above the higher strike of the long call option. In both situations, the maximum loss is equal to the difference between the strike price between the call options (or put options) minus the net premium received while entering the trade.
- Upper Breakeven Price = Strike Price of Short Call Option + Net Premium Received
- Lower Breakeven Price = Strike Price of Short Put Option – Net Premium Received
Using the above formula you can calculate the breakeven price for the iron butterfly options strategy.
Suppose there is a stock trading at $200 for oct contract with a lot size of 100. To implement the iron butterfly options strategy a trader buys a $210 call option at $6 and short a $200 call option at $10 simultaneously buys a put option of $190 at $6 and sells a $200 put option at $10. So the net premium cost for the trader would be $8 x 100 (lot size = 100) = $800.
If the stock expires at $200, then the trader will receive $800 as profit minus the commission he paid for the spread. But if the stock expires at $175, then the call options will expire worthlessly he will make a profit if $4 x 100 = $400.
In case of the put options, the $200 put will be valued at $25 at expiration and the $190 strike put will be at $15, so the trader will make a loss of $6 x 100 = $600, so the net loss from this strategy would be $600 – $400 = $200.
The one main limitation of this options strategy is that it is a limited profit and limited loss strategy and it is strictly for sidewise to a neutral market condition. If the volatility increases the chances of accruing loss increase significantly.
The second and most important one is if your commission is high, you should not consider this strategy as it is a multi-legged options strategy and you have to buy and sell four different options contacts.
- The iron butterfly options strategy is a credit spread that comprises four options contracts, which limits both potential loss and potential profit.
- This strategy is best applied when there is lower volatility in the market.
- Maximum profit in the strategy achieved when the price of the underlying asset equals the strike price of the short call option or the short put option.
- Maximum loss occurs when the price of the underlying is greater than or equals the strike price of long call option or price of underlying less than or equals the strike price of the long put option.
Well, this strategy is famous among the experienced options trader, who knows the market conditions very well. By applying this option strategy traders easily earn quite a good amount of return as the cost of deployment of this strategy is quite low.