How to Master the Iron Butterfly Strategy (Updated 2018)

Iron Butterfly Options Trading Strategy

Introduction to trading the Iron Butterfly Strategy:

The iron butterfly strategy, also called Ironfly, is a limited loss, limited profit options trading strategy.  It gets it’s name from a group of option strategies known as the wingspreads.  The iron butterfly is created by combining a bear call spread and a bull put spread.  If you’re not sure how to use a call then check out my covered call article here.

In order for the iron butterfly to work, you need to make sure that both have identical expiration dates that converge at a middle strike price.  This gives the appearance, when drawn out, of a butterfly.

Iron butterfly strategy involves:

A – Buying and selling of Call, and, Put options.

B – Involves four options contracts.

C – All options have the same underlying asset with same expiry date.

D – It involves three equidistant strikes.       


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Construction of the Iron Butterfly:

There are 4 parts to setting up the Iron Butterfly:

  1. Buy 1 Out of the Money Call   – Higher Strike          
  2. Sell 1 At the Money Call     – Middle Strike                   
  3. Sell 1 At the Money Put      – Middle Strike               
  4. Buy 1 Out of the Money Put  – Lower Strike                

This gives a net credit of the premium to the trader.

Payoff:

When the underlying stock is expected to have a low volatility, the Iron Butterfly strategy has a higher possibility of generating a limited profit. In case, the volatility increases, the loss is limited. Thus, this is a limited loss, and, limited profit strategy.

Max Profit:

Max Profit = Net Premium Received – Commissions Paid; and this happens when the underlying asset expires at the Middle Strike Price (i.e., at the short Call/Put Strike Price).

Max Loss:

Max Loss for the Iron Butterfly would occur in either of these two scenarios:

1 – On expiry, the underlying asset closes at or above the bought Call Strike, and it can be calculated as:

Max Loss = Difference between the Call sold and the Call bought, less Net Premium Received, plus Commissions Paid

Or

2 – On expiry, the underlying asset closes at or below the bought Put Strike, and it can be calculated as:

Max Loss = Difference between the Put sold and the Put bought, less Net Premium Received, plus Commissions Paid

Break-even:

There are two break-even points:

Upper Break-even Point = Strike Price of Short Call + Net Premium received

Lower Break-even Point = Strike Price of Short Put –  Net Premium received

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Motivation:

This strategy should be executed when the trader expects the volatility to be low. The idea behind this strategy is to earn as much premium as possible on the sold options. With the passage of time, option premiums decay; and, hence the best time to execute this strategy would be at least two to three days before the expiry; for weekly options – this is not a strict rule though; and, the trader needs to consider the volatility.

Remember to execute this strategy on a stock which has high liquidity, as the trader runs the risk of assignment on the sold options.

Example 1:

Suppose, stock A is trading at $50 in May. An options trader constructs an iron butterfly by:

1 – Buying a May 60 Call for $80

2 – Selling a May 50 Call for $400

3 – Selling a May 50 Put for $400

4 – Buying a May 40 Put for $80

Iron Butterfly

Payoff Diagram:

Iron Butterfly

 

  • On expiry, if the stock A is still trading at $50

All the options expiry worthless, and the trader gains the entire Net Premium received. This is the maximum profit the trader can make.

  • On expiry, if the stock A is trading at $40

All the options except the May 50 Put sold expire worthless. The May 50 Put will have an intrinsic value of $1000. Subtracting the Net Premium received from $1000, the trader suffers the maximum loss of $360.

  • On expiry, if the stock A is trading at $60

All the options except the May 50 Call sold expire worthless. The May 50 Call will have an intrinsic value of $1000. Subtracting the Net Premium received from $1000, the trader suffers the maximum loss of $360.

Effect of Volatility:

Increase in volatility, everything else being the same, would have a negative impact on this strategy.

Effect of Time Decay:

The passage of time, everything else being the same, would have a positive impact on this strategy.

Assignment Risk:

The sold options run the risk of getting assigned/exercised. Should this happen, the trader can decide to either close out the resulting position in the market or to exercise one of the options (Put or Call – as the case be).

Example 2:

Suppose, Google is trading at $941 on May 16, 2017, and the options expire on May 19, 2017.  

An options trader constructs an iron butterfly by:

1 – Buying a May 942.5 Call for $2.74

2 – Selling a May 940 Call for $4.39

3 – Selling a May 940 Put for $3.20

4 – Buying a May 937.5 Put for $2.36

Iron Butterfly

For this position, the maximum loss is $1, and the maximum gain is $249.

The table below shows the payoff; at different prices of Google, on expiry.

Iron Butterfly

Iron Butterfly Payoff Diagram:

Iron Butterfly

 

*Assignment Risk:

The sold options run the risk of getting assigned/exercised. Should this happen, the trader can decide to either close out the resulting position in the market or to exercise one of the options (Put or Call – as the case be).

Conclusion:

The Iron Butterfly options strategy is a great way for day traders to increase their income at a steady pace, while also limiting their potential risk.   As always, make sure to practice responsible trading habits.

Hope you enjoyed this article and be sure to like and share it on Facebook and Twitter!

-J

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