Reverse Iron Butterfly : Take Advantage Of Increased Volatility

Introduction Reverse Iron Butterfly Option Strategy

Reverse iron butterfly

The reverse iron butterfly is an options trading strategy that is executed with the aim to profit from the volatility of the price of the underlying security. Hence, significant swings in the price of the underlying security will increase the probability of the reverse iron condor turning a profit. Due to the way it is structured, it has a limited profit potential and a limited loss potential. The reverse iron condor is created with both puts and calls with the same expiration date but with different strike  or exercise prices.

Reverse iron butterfly – A net debit trade

The reverse iron butterfly is created by selling 2 out of the money options and buying 2 at the money options. Since the options premium are greater for at the money options than out of the money options, executing a reverse iron butterfly trade will result in a net debit.

Comparable Option Strategies

The short put butterfly, short butterfly and reverse iron butterfly are all options trading strategies that result in limited profit and loss payoff profiles, while anticipating spikes in volatility of the underlying security within a certain time frame.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Anticipate Increased Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Potential for limited losses
Step 7 : Calculating maximum loss of reverse iron butterfly
Step 8 : Limited profit potential
Step 9 :  Calculating the maximum profit of reverse iron butterfly
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Execute a reverse iron condor
Step 12 : Exit Trade &  Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

With regards to an iron butterfly, an options trader should look for economic or fundamental events that will cause increase in volatility. An economic report or a fundamental event that affects the valuation of an underlying security. Option traders should also look out for certain charts such as:

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 :Outlook – Anticipate Increased Volatility

An options trader that executes a reverse iron butterfly is anticipating spikes in volatility levels of the price of the underlying security. The worse case scenario is that that price of the underlying security stays constant till expiration and the trader loses money on the trade.

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Step 3 :Study the option chain

Examine the options chain and select options to construct the reverse iron butterfly.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

After selecting the options for the construction of the reverse iron butterfly, the trader should perform breakeven analysis and calculate the breakeven points in the reverse iron butterfly. This can only be calculated if the trader knows the premiums of the options involved in the construction of the reverse iron butterfly.

The breakeven points are price points at which there are neither profit nor loss.There are 2 breakeven points in a reverse iron butterfly. There is a downside breakeven point and an upside breakeven point.

The downside breakeven point is:

Exercise price of bought put or call + net debit

The upside breakeven point is:

Exercise price of bought put or call – net debit

The exercise price of the bought put and call are the same as they are at the money options. When the price of the underlying security trades above the upside breakeven point, a profit is realisable when the trade is liquidated. When the price of the underlying security trades below the breakeven point, a profit is also realisable when the trade is liquidated.

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Step 5: Understand Your Profit Zones

Reverse iron butterfly

After the upside and downside breakeven points are calculated, the options trader will understand where the profit zone is to the left of the downside breakeven point and to the right of the downside breakeven point.

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Step 6 : Potential for limited losses

The reverse iron butterfly has a limited loss potential. This occurs when the price of the underlying security stays stagnant till the expiration of the options. Hence, as the options expire, the price of the underlying security is equal to the exercise price of the bought put and call. At that price point, all the options in the reverse iron butterfly expire worthless. When that happens, the trader loses a maximum amount equal to the net debit. Of course, if one were to take factor in the commissions paid to the broker, the losses would be slightly greater than the preceding scenario.

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Step 7 : Calculating maximum loss of reverse iron butterfly

The maximum loss can thus be calculated as :

Net debit + commissions paid to the broker

Condition(s) under which maximum loss occurs:

Exercise price of the bought put or call =  price of underlying security

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Step 8 : Limited profit potential

The profit potential of the reverse iron butterfly is limited because of the way it is structured. That is, every long call has a corresponding short call at a higher strike price and every long put has a corresponding short put at a downside strike price. As a result, the written options limit the profit of the trade even if the price of the underlying security makes a significant move in either direction. In the absence of the written options, the trade stands to make a potentially larger profit. A reverse iron butterfly without the written options is also known as a long straddle.

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Step 9 :  Calculating the maximum profit of reverse iron butterfly

The maximum profit can be calculated as :

Exercise price of the out of money call – Exercise price of the at the money call – net debit – commissions paid to broker

OR

Exercise price of the at the money put – Exercise price of the out of the money put – net debit – commissions paid to the broker

There are 2 conditions under which the reverse iron condor experiences  a maximum profit. They are:

-Price of the underlying security must be greater than or equal to the strike(exercise) price of the out of the money call

-Price of the underlying security must be less than or equal to the strike(exercise) price of the out of the money put

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Step 10 : Calculate Risk & Reward Ratio

Calculate the risk and reward ratio to determine attractiveness of the trade relative to other trades with the same payoff profile. Examine the pros and cons of one trade against another.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Execute a reverse iron condor

  • Write 1 out of the money put
  • Buy 1 at the money put
  • Buy 1 at the money call
  • Sell 1 out of the money call

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Step 12 : Exit Trade &  Record Trade In Diary

Exit the trade and record the trade in a diary or journal. Perform periodic analysis and reflection to become a better trader.

Example Of A Reverse Iron Butterfly

QQQ Corp is trading at a price of $60. A trader executes a reverse iron butterfly on QQQ by:

  • Writing 1 Dec 55 put @ $1
  • Buying 1 Dec 60 put @ $2.50
  • Buying 1 Dec 60 call @ $2.50
  • Writing 1 Dec 65 call @ $1

As a result of the trade being entered into above, the net debit is:

($2.50 + $2.50 – $1 – $1) x 100 = $300

Let us examine the scenario where the price of QQQ trades at $60 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
Short 1 Dec 55 put $1 $0 +$1
Long 1 Dec 60 put $2.50 $0 -$2.50
Long 1 Dec 60 call $2.50 $0 -$2.50
Short 1 Dec 65 call $1 $0 +$1
Overall loss -$3

As you can see, there is an overall loss per share of $3. The total loss is:

$3 x 100 = $300

$300 is also known as the maximum loss and it occurs when the strike price of the long put or call is equal to the trading price of the underlying security. This is the worse case scenario for a reverse iron butterfly. Hence, when a trader executes a reverse iron butterfly, it is imperative that he predicts a significant enough of a price move that will made the trade profitable. The price of the underlying security must trade above the upside breakeven point or lower than the downside breakeven point for the trader to make a profit.

Let us examine the scenario where the price of QQQ trades at $50 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
Short 1 Dec 55 put $1 $5 -$4
Long 1 Dec 60 put $2.50 $10 +$7.50
Long 1 Dec 60 call $2.50 $0 -$2.50
Short 1 Dec 65 call $1 $0 +$1
Overall profit +$2

The total profit is thus:

$2 x 100 = $200

This is also the maximum profit attainable. It can be calculated as:

($60 – $55) x 100 – $300 = $200

$300 in the calculation above is the net debit.

Let us examine the scenario where the price of QQQ trades at $70 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
Short 1 Dec 55 put $1 $0 +$1
Long 1 Dec 60 put $2.50 $0 -$2.50
Long 1 Dec 60 call $2.50 $10 +$7.50
Short 1 Dec 65 call $1 $5 -$4
Overall profit +$2

The total profit here is also :

$2 x 100 = $200

$200 is also the maximum profit.

Hence, wide swings in underlying security prices will result in a greater probability of making a maximum profit.

The breakeven points for QQQ is:

Downside breakeven point $60 – $3 = $57
Upside breakeven point $60 + $3 = $63

Therefore, if the price of the underlying security trades between $57 and $63, the reverse iron butterfly trade will make a loss.

Reverse iron butterfly vs long straddle

A reverse iron butterfly has a limited profit potential. A long straddle however, has unlimited profit potential. An options trader should compare a reverse iron butterfly and compare the maximum profit attainable if the price of the underlying security were to trade at a certain price. For example, if the price of the underlying security were to trade at $X a month later, what would be the difference in the maximum profit attainable for the reverse iron butterfly vs the long straddle. A higher maximum profit attainable should determine the strategy to be used.

The benefit of a reverse iron butterfly trade is that it takes a lower cost to enter the trade as compared to establishing a long straddle.

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