The iron butterfly spread is a limited risk, limited profit trading strategy that is structured for a larger probability of earning a smaller limited profit when the underlying stock is perceived to have a low volatility.
|Iron Butterfly Construction|
|Buy 1 OTM Put|
Sell 1 ATM Put
Sell 1 ATM Call
Buy 1 OTM Call
To setup an iron butterfly, the options trader buys a lower strike out-of-the-money put, sells a middle strike at-the-money put, sells a middle strike at-the-money call and buys another higher strike out-of-the-money call. This results in a net credit to put on the trade.
Maximum profit for the iron butterfly strategy is attained when the underlying stock price at expiration is equal to the strike price at which the call and put options are sold. At this price, all the options expire worthless and the options trader gets to keep the entire net credit received when entering the trade as profit.
The formula for calculating maximum profit is given below:
- Max Profit = Net Premium Received - Commissions Paid
- Max Profit Achieved When Price of Underlying = Strike Price of Short Call/Put
|Iron Butterfly Payoff Diagram|
Maximum loss for the iron butterfly strategy is also limited and occurs when the stock price falls at or below the lower strike of the put purchased or rise above or equal to the higher strike of the call purchased. In either situation, maximum loss is equal to the difference in strike between the calls (or puts) minus the net credit received when entering the trade.
The formula for calculating maximum loss is given below:
- Max Loss = Strike Price of Long Call - Strike Price of Short Call - Net Premium Received + Commissions Paid
- Max Loss Occurs When Price of Underlying >= Strike Price of Long Call OR Price of Underlying <= Strike Price of Long Put
There are 2 break-even points for the iron butterfly position. The breakeven points can be calculated using the following formulae.
- Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
- Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Suppose XYZ stock is trading at $40 in June. An options trader executes an iron butterfly by buying a JUL 30 put for $50, writing a JUL 40 put for $300, writing another JUL 40 call for $300 and buying another JUL 50 call for $50. The net credit received when entering the trade is $500, which is also his maximum possible profit.
On expiration in July, XYZ stock is still trading at $40. All the 4 options expire worthless and the options trader gets to keep the entire credit received as profit. This is also his maximum possible profit.
If XYZ stock is instead trading at $30 on expiration, all the options except the JUL 40 put sold expire worthless. The JUL 40 put will have an intrinsic value of $1000. This option has to be bought back to exit the trade. Thus, subtracting his initial $500 credit received, the options trader suffers his maximum possible loss of $500. This maximum loss situation also occurs if the stock price had gone up to $50 or beyond instead.
To further see why $500 is the maximum possible loss, lets examine what happens when the stock price falls below $30 to $25 on expiration. At this price, only the JUL 30 put and the JUL 40 put options expire in-the-money. The long JUL 30 put has an intrinsic value of $500 while the short JUL 40 put is worth $1500. Selling the long put for $500, and factoring in the intial credit of $500 received, he still need to fork out another $500 to buy back the short put worth $1500. Thus his maximum loss is still $500.
Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the iron butterfly as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.
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The following strategies are similar to the iron butterfly in that they are also low volatility strategies that have limited profit potential and limited risk.
The Reverse Iron Butterfly
The converse strategy to the iron butterfly is the reverse or short iron butterfly. Reverse iron butterfly spreads are used when one perceives the volatility of the price of the underlying stock to be high.
The iron butterfly belongs to a family of spreads called wingspreads whose members are named after a myriad of flying creatures.
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