Home » Option Strategies – Iron Butterfly Option Strategy ?

Option Strategies – Iron Butterfly Option Strategy ?

What is the Iron Butterfly Option Strategy ?

Options provide a variety of money-making tactics that cannot be matched with traditional equities, and not all of them are high-risk endeavors. The iron butterfly technique, for example, can provide consistent income while limiting risks and profits.
Because each strategy is named after a flying species like a butterfly or condor, the iron butterfly option strategy approach is part of a collection of option strategies known as “wingspreads.” A bear call spread and a bull put spread with the same expiration date that converge at a middle strike price make up the strategy.

The “body” of the butterfly is formed by a short call and put sold at the middle strike price, and the “wings” are formed by a call and put purchased above and below the middle strike price, respectively.
In two ways, this approach differs from the standard butterfly spread. The basic butterfly position is a sort of debit spread, and it is a credit spread that provides the investor a net premium at open. Second, instead of three contracts, the approach calls for four.

Why is Iron Butterfly Option Strategy best and when?

The iron butterfly method is a credit spread that combines four options to restrict both risk and reward possibilities.
During periods of decreased market volatility, the technique works best. So when market is not moving then Iron butterfly works best.

NOTE: The Iron butterfly strategy (short) brings profits only if Volatility drops in a few days, if it does not drop then we recommend to close the Iron butterfly strategy. If not closed this trade will result in loss with even a slight increase in volatility. Iron Butterfly is a Volatility playing strategy and not that much of directional or non-directional option strategy like what most traders think of. Iron Butterfly strategy results depends a lot on what happens to volatility after the trade is made. Direction of the stock within a small range will not effect much if lot of time remains for expiry. However if stock moves a lot fast, and volatility does not decrease, the trade stands to lose. No strategy is 100 % successful but it’s only the edge of winnings we need to consider and timing of trade placement. 

Example of Iron Butterfly Option Strategy?

Let’s imagine Delta named Company rose to 500 in August, and the trader wishes to benefit by using an iron butterfly. The trader receives a 10.00 premium for writing both a September 500 call and a September put, and also buys a September 600 call and a September 400 put for 2 each. After subtracting the price paid for the long bets from the premium received for the short positions (2000-400) assuming the lot size is 100, the net result is an immediate 1600 credit.
Short call and put premium received = 10.00 x 2 x 100 shares = 2000
Long call and put premium = 2 x 2 x 100 shares = 400
Initial net premium credit: 2000 – 400 = 1600

How to Make the Iron Butterfly Work for You?

Iron butterflies limit the amount of money that can be made as well as the amount of money that can be lost. They are designed to allow traders to keep at least a portion of the net premium paid when the price of the underlying securities or index closes between the upper and lower strike prices, which occurs when the price of the underlying security or index closes between the upper and lower strike prices. This approach is used by market participants during periods of lower volatility, when they assume the underlying instrument will remain within a particular price range until the options expire.

Break Even points in Iron Butterfly Option strategy

the closer the underlying closes at expiration to the middle strike price, the larger the profit,  If the price closes above the strike price of the upper call or below the strike price of the lower put, the trader will lose money. By adding and subtracting the premium received from the middle strike price, the breakeven point may be calculated.
The breakeven points in the previous example are computed as follows:

Center/Middle point is 500
Upon opening, the net premium paid was 1600 and per share will be 16 per 100
500 + 16 (x 100 shares = 1600) = 516 is the upper breakeven mark.
Lower breakeven point  = 500-16 (for a total of 100 shares)= 484

Below figure shows the profit and loss chart from Sensibull for Short Iron Butterfly Option strategy

Above marked are Max Profit point where we sell call and put

Max Loss points are marked in red towards both ends.

Lower Strike Price , Center Strike Price, and Upper Strike Price are the three strike prices 400,500,600 in above example which can adjusted for max profit and gain. Sensibull can be used for strategy designing.

Losing Scenario

If the price rises above or below the breakeven points above, the trader will pay more to buy back the short call or put than received initially, resulting in a net loss.

If Delta named Company closes at 600 in November, all of the options in the spread, except the call options, will expire worthless. To close out the position, the trader must buy back the short 500 call for 15,000 (650 market price – 500 strike price x 100 shares) and is compensated with a 5,000 premium on the 600 call (650 market price – 600 strike price = 50 x 100 shares). As a result, the net loss on the calls is 10,000, which is removed from the initial net premium of 2,000 to arrive at an overall net loss of 8000.

We adjust the wings of the setup wider to adjust the Max profit and Max Loss.

Iron butterflies can also be inverted so that long positions are taken at the middle strike price while short positions are placed at the wings. This can be done profitably during periods of high volatility in the underlying instrument. Below are both Long Iron Butterfly where big movement is anticipated and Short Iron Butterfly when we expect a range bound movement explained.

Long Iron Butterfly Option Strategy ?

Market View in this strategy is Range-bound, not moving

Below figure shows the profit and loss chart from Sensibull for Long Iron Butterfly Option strategy

Long Iron Butterfly Option Strategy trade Setup?

Buy a put and call at the same strike near the stock price. Your view is that the stock will go down or up. Sell a lower put and a higher call on both sides for reducing premium
Premium

When To Use Long Iron Butterfly Option Strategy?

  • When the stock is going to move big in one direction
  • Avoid buying high IV which cause loss

Advantages

  • Lower premium than straddle
  • Low Vega risk and theta risk

Disadvantages

  • Low probability of success

Impact of Time and Volatility

  • Loses time value every day
  • Gains slightly if IV goes up

Short Iron Butterfly Option Strategy ?

Market View in this strategy is Range-bound, not moving

Below figure shows the profit and loss chart from Sensibull for Short Iron Butterfly Option strategy

Short Iron Butterfly Option Strategy trade Setup?

Sell a put and call at the same strike near the stock price. Your view is that the stock wont go down or up. Buy a lower Put and a higher call for protection on both sides just in case you’re wrong.

When To Use Short Iron Butterfly Option Strategy?

  • If the stock will stay still and expire near the sell call and sell put strike max profit is achieved.
  • Avoid trending markets where it will result in loss.
  • Avoid selling low IV where when IV increases premium increases thus causing loss.

Advantages

  • Delta Neutral – Immune to small moves.
  • Make money if nothing happens or no movement
  • Limited loss – Max loss is defined.
  • Low vega risk and Theta risk

Disadvantages

  • None

Impact of Time and Volatility

  • Gains time value everyday
  • Loses moderately if IV goes up

Conclusion:

  • Iron Butterfly strategy is implemented by selling ATM options of both calls and puts and buying just OTM options to protect them.
  • Iron Butterfly strategy is a volatility trade and not a directional or non-directional trade. Timing of volatility to drop or increase is noted and is important, else the trade may lose.
  • This trade is  traded by professionals who have an idea of when the volatility is to be stable vs sudden moves (may drop or raise)
  • Waiting till expiry is not recommended.
  • Exit whenever you are making a reasonable or good enough profits as stock market it is never 100% sure of anything.

Please read our Iron Condor Strategy here.

 

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