Introduction To Iron Butterfly Option Strategy
An iron butterfly spread is an options strategy that attempts to profit from low volatility of the underlying security, that is, range bound trading. Due to the way combinations of options are purchased and sold simultaneously, there is a limit to profit and loss. The iron butterfly is a combination of a bear call spread and a bull put spread. All options utilised have the same expiration month and are derived from the same underlying security. The disadvantage to this strategy is that there is a maximum profit at only a single price point.
A Net Credit Trade
Executing an iron butterfly would result in a net credit as the premiums collected will exceed the premiums paid.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Low volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited losses and risk
Step 7 : Loss calculation of an iron butterfly
Step 8 : A limited profit strategy
Step 9 : Calculate Profit
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade
Step 12 : Exit Trade
Step 13 : Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
The trader must have an eye out on expected economic events that are expected to cause volatility. The absence of these events are a good thing. In the absence of any positive or negative news related to the underlying security is also a good thing. As a result, the price of the underlying security is expected to be less volatile. Looking to the charts, the trader should look for prices that trade within very narrow range, or better still, stagnant. Some of the chart patterns that traders should look out for are:
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 : Outlook – Low volatility
The best case scenario is that the price of the underlying security stays constant, stagnate or move very little. A low volatility scenario is what a trader looks out for when he wants to use an iron butterfly strategy. Before an option trader executes an iron butterfly, he must first calculate the breakeven points. If the price of the underlying security trades between the breakeven points, the trader can earn a profit.
Step 3 :Study the option chain
Examine the option chain and select the options(with different strike prices) that can be used in an iron butterfly.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
There are 2 breakeven price points. There is an upper and lower breakeven point. At these price points, the trader experiences neither profit nor loss.
Upside breakeven point = Net credit received + exercise price of short call
Downside breakeven point = exercise price of short put – Net credit received
The upside breakeven point is higher than the downside breakeven point.
Step 5: Understand Your Profit Zones
After calculating the breakeven points, the trader is able to understand where the profit zone is. The profit zones is any price point between the breakeven points.
Step 6 : Limited losses and risk
The iron butterfly is structured to reduce risk and hence limit losses. A maximum loss will occur when the trading price of the underlying security is less than or equal to the exercise price of the bought put or greater than or equal to the exercise price of the bought call.
Step 7 : Loss calculation of an iron butterfly
The maximum loss of an iron butterfly strategy is:
Difference in exercise prices of long and short call + commissions paid to broker + net credit received
Step 8 : A limited profit strategy
In an iron butterfly strategy, there are sold ATM puts and ATM calls of the same exercise price besides having to buy OTM puts and calls. The iron butterfly strategy will experience a maximum and limited profit when the trading price of the underlying security is equal to the exercise price of the sold ATM puts and calls. In executing an iron butterfly, the trader receives a net credit. When the trading price of the underlying security is equal to that of the exercise price of the shorted options, all the options will expire worthless and the trader gets to keep the net credit.
Step 9 : Calculate Profit
The maximum profit can be calculated as :
Net credit received – commissions paid to the broker
The reason as to why a net credit is received by the trader who executes an iron butterfly is because the premium of the written options exceeds the premium of the bought options.
Step 10 : Calculate Risk & Reward Ratio
Next, calculate the risk and reward ratio. This would be possible only after understanding how to calculate the maximum profit and loss. Ascertain that the trade is attractive compared to other potential trades that could be set up.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade
The ratio of long OTM puts to short ATM puts to short ATM calls to long OTM calls is 1:1:1:1.
In general, in range bound markets, the option trader should:
- Long 1 OTM call near the resistance point
- Short 1 ATM call near the midpoint of the trading range
- Short 1 ATM put near the midpoint of the trading range
- Long 1 OTM put near the support point
Step 12 : Exit Trade
General guidelines for exiting the iron butterfly trade
- The profit range is experience between the upside and downside breakeven points. If the iron butterfly has a reasonable profit of 50% or more and there are 30 days left till expiration, consider closing the trade entirely especially if market conditions have changed and there is a chance of the underlying trading outside of the breakeven points for the remaining life of the options.
- If the price of the underlying security is trading below the downside breakeven point, the option trader can let the options expire worthless and take a loss especially if there is little chance that the underlying will move to the profit range, that is, the price range between the downside and upside breakeven points.
- If the price of the underlying security is trading above the upside breakeven point, close out the position to avoid assignment. If assignment occurs, exercise the long position options to cover the assigned underlying.
Step 13 : Record Trade In Diary
Last but not least record the trade in a diary. Reflect on the process and find ways to become a better trader.
Example Of An Iron Butterfly
TTT Corp is currently trading at a price of $50. A trader decides to execute an iron butterfly.He buys a December 45 put, shorts a December 50 put, shorts a December 50 call and longs a December 55 call. The price of the December 45 put and the December 55 call are both worth $1 each. The price of the December 50 put and December 50 call are both worth $3 each.
The net credit is thus :
(($3 x 2) – ($1 x 2 )) x 100 = $400
When the price of company trades at $50 on expiration, the options expire worthless and the trader gets to keep the net credit received.
But if the price of the company trades at $40 or $60 on expiration, the trader makes a maximum loss when he closes his positions.
At $40:
| Beginning value | Ending value | Profit/loss | |
| Long December 45 put | $100 | $500 | Gain = $400 |
| Short December 50 put | $300 | $1000 | Loss = $700 |
| Short December 50 call | $300 | $0 | Gain = $300 |
| Long December 55 call | $100 | $0 | Loss = $100 |
| Maximum loss of iron butterfly | $100 |
At $60:
| Beginning value | Ending value | Profit/loss | |
| Long December 45 put | $100 | $0 | Loss = $100 |
| Short December 50 put | $300 | $0 | Gain = $300 |
| Short December 50 call | $300 | $1000 | Loss = $700 |
| Long December 55 call | $100 | $500 | Gain = $400 |
| Maximum loss of iron butterfly | $100 |
As you can see, the maximum loss is $100. The maximum loss can also be calculated as:
($55 – $50) x 100 – $400[net credit]
= $100
Long put butterfly and iron butterfly
The long put butterfly has a comparable payoff profile to the iron butterfly.
Read : Execute A Long put butterfly : profit from low volatility conditions