Iron Butterfly Explained

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Iron Butterfly

What is an Iron Butterfly?

An iron butterfly is an options trade that uses four different contracts as part of a strategy to benefit from stocks or futures prices that move within a defined range. The trade is also constructed to benefit from a decline in implied volatility. The key to using this trade as part of a successful trading strategy is forecast a time when option prices are likely to decline in value generally. This usually occurs during periods of sideways movement or a mild upward trend. The trade is also known by the nickname “Iron Fly.”

Key Takeaways

  • Iron Butterfly trades are used as a way to profit from price movement in a narrow range during a period of declining implied volatility.
  • The construction of the trade is similar to that of a short-straddle trade with a long call and long put option purchased for protection.
  • Traders need to be mindful of commissions to be sure they can use this technique effectively in their own account.
  • Traders need to be aware that his trade could lead to a trader acquiring the stock after expiration.

How an Iron Butterfly Works

The Iron Butterfly trade is created with four options consisting of two call options and two put options. These calls and puts are spread out over three strike prices, all with the same expiration date. The goal is to profit from conditions where the price remains fairly stable and the options demonstrate declining implied and historical volatility.

It can also be thought of as a combined option trade using both a short straddle and a long strangle, with the straddle positioned on the middle of the three strike prices and the strangle positioned on two additional strikes above and below the middle strike price.

The trade earns the maximum profit when the underlying asset closes exactly on the middle strike price on the close of expiration. A trader will construct an Iron Butterfly trade with the following steps.

  1. The trader first identifies a price at which they forecast the underlying asset will rest on a given day in the future. This is the target price.
  2. The trader will use options which expire at or near that day they forecast the target price.
  3. The trader buys one call option with a strike price well above the target price. This call option is expected to be out-of-the-money at the time of expiration. It will protect against a significant upward move in the underlying asset and cap any potential loss at a defined amount should the trade not go as forecast.
  4. The trader sells both a call and a put option using the strike price nearest the target price. This strike price will be lower than the call option purchased in the previous step and higher than the put option in the next step.
  5. The trader buys one put option with a strike price well below the target price. This put option is expected to be out-of-the-money at the time of expiration. It will protect against a significant downward move in the underlying asset and cap any potential loss at a defined amount should the trade not go as forecast.

The strike prices for the option contracts sold in steps two and three should be far enough apart to account for a range of movement in the underlying. This will allow the trader to be able to forecast a range of successful price movement as opposed to a narrow range near the target price.

For example, if the trader thinks that, over the next two weeks, the underlying could land at the price of $50, and be within a range of five dollars higher or five dollars lower from that target price, then that trader should sell a call and a put option with a strike price of $50, and should purchase a call option at least five dollars higher, and a put option at least five dollars lower, than the $50 target price. In theory, this creates a higher probability that the price action can land and remain in a profitable range on or near the day that the options expire.

Deconstructing the Iron Butterfly

The strategy has limited upside profit potential by design. It is a credit-spread strategy, meaning that the trader sells option premiums and takes in a credit for the value of the options at the beginning of the trade. The trader hopes that the value of the options will diminish and culminate in a significantly lesser value, or no value at all. The trader thus hopes to keep as much of the credit as possible.

The strategy has defined risk because the high and low strike options (the wings), protect against significant moves in either direction. It should be noted that commission costs are always a factor with this strategy since four options are involved. Traders will want to make certain that the maximum potential profit is not significantly eroded by the commissions charged by their broker.

The Iron butterfly trade profits as expiration day approaches if the price lands within a range near the center strike price. The center strike is the price where the trader sells both a call option and a put option (a short strangle). The trade diminishes in value as the price drifts away from the center strike, either higher or lower, and reaches a point of maximum loss as the price moves either below the lower strike price or above the higher strike price.

Iron Butterfly Trade Example

The following chart depicts a trade setup that implements an Iron Butterfly on IBM.

In this example the trader anticipates that the price of IBM shares will rise slightly over the next two weeks. The company released its earnings report two weeks previous and the reports were good. The trader believes that the implied volatility of the options will generally diminish in the coming two weeks, and that the share price will drift higher. Therefore the trader implements this trade by taking in an initial net credit of $550 ($5.50 per share). The trader will make a profit so long as the price of IBM shares moves in between 154.50 and 165.50.

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If the price stays in that range on the day of expiration, or shortly before it, the trader can close the trade early for a profit. The trader does this by selling the call and put options that were previously purchased, and buying back the call and put options that were sold at the initiation of the trade. Most brokers allow this to be done with a single order.

An additional trading opportunity available to the trader occurs if the price stays below 160 on the day of expiration. At that time the trader can let the trade expire and have the shares of IBM (100 per put contract sold) put to them for the price of $160 per share.

For example, suppose the price of IBM closes at $158 per share on that day, and assuming the trader lets the options expire, the trader would then be obligated to buy the shares for $160. The other option contracts all expire worthless and the trader has no need to take any action. This may seem like the trader has simply made a purchase of stock at two dollars higher than necessary, but remember, the trader took in an initial credit of $5.50 per share. That means the net transaction can be seen differently. The trader was able to purchase shares of IBM and collect $2.50 profit per at the same time ($5.50 less $2.00).

Most of the effects of the Iron Butterfly trade can be accomplished in trades that require fewer options legs and therefore generate fewer commissions. These include selling a naked put or buying a put-calendar spread, however the Iron Butterfly provides inexpensive protection from sharp downward moves that the naked put does not have. The trade also benefits from declining implied volatility, which the put calendar spread cannot do.

What Is an Iron Butterfly Option Strategy?

Options offer many strategies to make money that cannot be duplicated with conventional securities and not all types of option trading are high-risk ventures. For example, the iron butterfly strategy can generate steady income while setting a dollar limit on the profit or loss.

What Is an Iron Butterfly?

The iron butterfly strategy is a member of a specific group of option strategies known as “wingspreads” because each strategy is named after a flying creature like a butterfly or condor. The strategy is created by combining a bear call spread with a bull put spread with an identical expiration date that converges at a middle strike price. A short call and put are both sold at the middle strike price, which forms the “body” of the butterfly, and a call and put are purchased above and below the middle strike price, respectively, to form the “wings”.

This strategy differs from the basic butterfly spread in two respects. First, it is a credit spread that pays the investor a net premium at open while the basic butterfly position is a type of debit spread. Second, the strategy requires four contracts instead of three.

For example, ABC Company has rallied to $50 in August and the trader wants to use an iron butterfly to generate profits. He or she writes both a September 50 call and put, receiving $4.00 of premium for each contract, and also buys a September 60 call and September 40 put for $0.75 each. The net result is an immediate $650 credit after the price paid for the long positions is subtracted from the premium received for the short ones ($800-$150).

Premium received for short call and put = $4.00 x 2 x 100 shares = $800

Premium paid for long call and put = $0.75 x 2 x 100 shares = $150

$800 – $150 = $650 initial net premium credit

How to Use the Iron Butterfly

Iron butterflies limit both the possible gain and loss. They are designed to allow traders to keep at least a portion of the net premium that is initially paid, which happens when the price of the underlying security or index closes between the upper and lower strike prices. Market players use this strategy when they believe the underlying instrument will stay within a given price range through the options’ expiration date. The nearer to the middle strike price the underlying closes at expiration, the higher the profit.

The trader will incur a loss if the price closes either above the strike price of the upper call or below the strike price of the lower put. The breakeven point can be determined by adding and subtracting the premium received from the middle strike price.

In the previous example, the breakeven points are calculated as follows:

Middle strike price = $50

Net premium paid upon open = $650

Upper break-even point = $50 + $6.50 (x 100 shares = $650) = $56.50

Lower break-even point = $50 – $6.50 (x 100 shares = $650) = $43.50

If the price rises above or below the breakeven points, the trader will pay more to buy back the short call or put than received initially, resulting in a net loss.

Let’s say ABC Company closes at $75 in November, which means all of the options in the spread will expire worthless except for the call options. The trader must therefore buy back the short $50 call for $2,500 ($75 market price – $50 strike price x 100 shares) in order to close out the position and is paid a corresponding premium of $1,500 on the $60 call ($75 market price – $60 strike price = $15 x 100 shares). The net loss on the calls is, therefore, $1,000, which is then subtracted from the initial net premium of $650 for a final net loss of $350.

Of course, it is not necessary for the upper and lower strike prices to be equidistant from the middle strike price. Iron butterflies can be created with a bias in one direction or the other, where the trader believes the underlying will rise or fall slightly in price but only to a certain level. If the trader believes ABC Company will rise to $60 by expiration, they can raise or lower the upper call or lower put strike prices accordingly.

Iron butterflies can also be inverted so that long positions are taken at the middle strike price while short positions are placed at the wings. This can be done profitably during periods of high volatility in the underlying instrument.

Advantages and Disadvantages

Iron butterflies provide several key benefits. They can be created using a relatively small amount of capital and provide steady income with less risk than directional spreads. They can also be rolled up or down like any other spread if price begins to move out of the range or traders can choose to close out half of the position and profit on the remaining bear call or bull put spread. The risk and reward parameters are also clearly defined. The net premium paid is the maximum possible profit the trader can reap from this strategy and the difference between the net loss between the long and short calls or puts minus the initial premium paid is the maximum possible loss the trader can incur.

Watch commission costs on iron butterflies because four positions must be opened and closed, and the maximum profit is seldom earned because the underlying will usually settle between the middle strike price and either the upper or lower limit. In addition, the chances of incurring a loss are proportionately higher because most iron butterflies are created using fairly narrow spreads,

The Bottom Line

Iron butterflies are designed to provide traders and investors with steady income while limiting risk. However, this type of strategy is only appropriate after thoroughly understanding the potential risks and rewards. Most brokerage platforms also require clients who employ this or similar strategies to meet certain skill levels and financial requirements.

Iron Butterfly

A long iron butterfly strategy combines a call spread and a put spread; it involves two call legs and two put legs, all with the same expiration date, generally with consistent distances between the 3 strike prices. The strategy gets its name from its 3-part structure, involving the two outer strikes (or “wings”) and the middle strike (representing the “body”).

Long Iron Butterfly

A long iron butterfly is created by selling a lower strike Put, purchasing both a higher strike Put and Call (middle Put and Call have matching strikes), and selling a consecutively higher strike Call. In order to be considered a standard iron butterfly, the 3 strike prices involved should be equidistant.

  • Sell to Open 1 XYZ 01/17/2020 25.00 Put
  • Buy to Open 1 XYZ 01/17/2020 27.50 Put
  • Buy to Open 1 XYZ 01/17/2020 27.50 Call
  • Sell to Open 1 XYZ 01/17/2020 30.00 Call

If the strike prices are not equidistant from each other, the butterfly is considered to be a “broken wing” butterfly.

The cost to purchase the middle strike Call and Put typically exceeds the premium received from selling the outer strike Call and Put; therefore, a long iron butterfly is typically established as a net debit position.

For use when investor anticipates:

  • Significant movement in security price (in either direction)
  • Higher volatility
  • Maximum Loss: Difference between middle strike price and outer strike price, less net credit
  • Maximum Gain: Initial net credit received
  • Gain from significant change in price of the underlying security (either up or down) by expiration

Assume it is July 17th, 2020, and John, an options trader, has identified XYZ as a stock he believes will make a sharp move, either higher or lower, over the next month. Therefore, he decides that a Long Iron Butterfly is an appropriate strategy, given his outlook and the limited risk that the strategy offers. XYZ is currently trading at $34.43, and John decides that 34.00 is an appropriate middle strike; it is around the money and John’s outlook is slightly more bearish than bullish. In addition, John feels that the 32.00 and 36.00 strike prices create an appropriate “wingspan,” since he feels that the underlying price will either be below $32.00 or above $36.00 at expiration. Lastly, John selects the August expiration, as it is 30 days away, which is right in line with his timing forecast.

Source: StreetSmart Edge

Here is the breakdown for John’s setup and trade:

  • Current XYZ Price = $34.43
  • Current Bid Price, XYZ 08/16/2020 32.00 Put = $0.11
  • Current Ask Price, XYZ 08/16/2020 34.00 Put = $0.60
  • Current Ask Price, XYZ 08/16/2020 34.00 Call = $1.07
  • Current Bid Price, XYZ 08/16/2020 36.00 Call = $0.26
  • John’s Trade:
    • Sell to Open 1 XYZ 08/16/2020 32.00 Put @ $0.11
    • Buy to Open 1 XYZ 08/16/2020 34.00 Put @ $0.60
    • Buy to Open 1 XYZ 08/16/2020 34.00 Call @ $1.07
    • Sell to Open 1 XYZ 08/16/2020 36.00 Call @ $0.26
    • Net Debit = -$0.11 + $0.60 + $1.07 – $0.26 = $1.30

The Profit/Loss profile for this trade is as follows:

Note: Chart depicts strategy at expiration

  • Maximum Gain = ($34.00 – $32.00) – $1.30 = $0.70
  • Maximum Loss = $1.30
  • Lower Break-Even = Middle Strike Price – Net Debit = $34.00 – $1.30 = $32.70
  • Upper Break-Even = Middle Strike Price + Net Debit = $34.00 + $1.30 = $35.30

Note: Commissions have been excluded to simplify the calculations. Short options can be assigned at any time and therefore option sellers assume the risk of assignment at any point up until and including expiration.

Commissions, taxes, and transaction costs are not included in any of these strategy discussions, but can affect final outcome and should be considered. Please contact a tax advisor to discuss the tax implications of these strategies. Many of the strategies described herein require the use of a margin account.

With a Qualified Spread, the purchased option is required to expire on the same or later expiration date than the option sold. When there is more than one possible way to pair available options in your Account, Schwab has the discretion to determine the spread pairings. Schwab may pair options in a manner that does not produce the lowest possible margin requirements.

Note: For butterfly and condor spreads, each option leg must have the same expiration date to qualify as those types of spreads.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Multiple leg options strategies will involve multiple commissions. Please read the options disclosure document titled “Characteristics and Risks of Standardized Options.” Member SIPC

Copyright В© 2020 Charles Schwab & Co., Inc. All rights reserved. Member SIPC. (0814-5276)

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