The reverse (short) iron butterfly is a limited risk, limited profit options trading strategy that is designed to make a profit when the underlying stock price makes a sharp move either up or down.
|Reverse Iron Butterfly Construction|
|Sell 1 OTM Put|
Buy 1 ATM Put
Buy 1 ATM Call
Sell 1 OTM Call
To setup a reverse iron butterfly, the options trader sells a lower strike out-of-the-money put, buys a middle strike at-the-money put, buys another middle strike at-the-money call and sells another higher strike out-of-the-money call. There will be a net debit taken to put on the trade.
Maximum gain for the reverse iron butterfly is limited and is achieved when the underlying stock price drops to be at or below the strike price of the short put option or rise to be above or equal to the strike price of the short call option. In either situation, maximum profit is equal to the difference in strike between the calls (or puts) minus the net debit taken when entering the trade.
The formula for calculating maximum profit is given below:
Maximum loss for the reverse iron butterfly is also limited and occurs when the underlying stock price at expiration is equal to the strike price of the long call and the long put options. At this price, all the options expire worthless and the options trader suffers a loss equal to the initial debit taken to enter the trade.
The formula for calculating maximum loss is given below:
There are 2 break-even points for the reverse iron butterfly position. The breakeven points can be calculated using the following formulae.
Suppose XYZ stock is trading at $40 in June. An options trader executes a reverse iron butterfly by selling a JUL 30 put for $50, buying a JUL 40 put for $300, buying another JUL 40 call for $300 and selling another JUL 50 call for $50. The net debit taken to enter this trade is $500, which is also his maximum possible loss.
On options expiration in July, XYZ stock is still trading at $40. All the 4 options expire worthless and the options trader suffers a loss equal to the intial debit taken of $500.
If XYZ stock is instead trading at $30 on expiration, all the options except the long JUL 40 put option expire worthless. The JUL 40 put will have an intrinsic value of $1000. Selling this put option will net the options trader $1000 and subtracting the initial $500 debit taken to enter this trade, the trader is left with $500 in profits. This is also his maximum possible profit. This maximum profit situation also occurs if the stock price had gone up to $50 or beyond instead.
To further see why $500 is the maximum possible profit, lets examine what happens when the stock price falls below $30 to $25 on expiration. At this price, only the short JUL 30 put and the long JUL 40 put options expire in-the-money. The short JUL 30 put has an intrinsic value of $500 while the long JUL 40 put is worth $1500. Selling the long put for $1500 to buy back the short put at $500, and factoring in the intial debit of $500 taken upon entering the trade, he is again left with $500 in profits.
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 reverse 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 reverse iron butterfly in that they are also high volatility strategies that have limited profit potential and limited risk.
The converse strategy to the reverse iron butterfly is the long iron butterfly. Long iron butterfly spreads are used when one perceives the volatility of the price of the underlying stock to be low.
The reverse iron butterfly belongs to a family of spreads called wingspreads whose members are named after a number of flying creatures.
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