Iron Butterfly

The Iron Butterfly Setup

For example, suppose you are looking at a stock, XYZ Corp that is trading for $100. To enter an Iron Butterfly you would:

Buy a money out of the money put with a strike price of $95 for $1.
Sell a money at the money put with a strike price of $100 for $4.
Sell a money at the money call with a strike price of $100 for $4.
Buy a money out of the money call with a strike price of $105 for $1.

All options would have the same expiration date. The net credit received when setting up this trade would be $6 ($8 received - $2 paid).

Who Should Consider It

This strategy is suitable for traders who expect minimal movement in the underlying asset and want to profit from this stability. It’s particularly useful in a market environment where the asset is predicted to hover around a known price point.

Strategy Explained

The Iron Butterfly seeks to maximize the premium collected from the sold at-the-money options, which will be worth the most if the stock price stays near the strike price at expiration. The long positions in the out-of-the-money put and call protect against substantial moves in either direction.

Breakeven Process

Calculations for the Iron Butterfly’s breakeven points include adding and subtracting total premium received with strike price on the sold option.

• Upper Breakeven = Strike of the sold calls + net credits taken = $100 + $6 = $106
• Lower breakeven = strike price of the sold put minus the net credit = $100-$6 =$94

Sweet Spot

The best case is when the stock price ends at the strike price of the sold options ($100) at expiration. This will be the maximum profit because the sold options will have expired worthless, and the trader will be left with the entire premium.

Max Profit Potential

The maximum profit for an Iron Butterfly is the initial net credit received, which is realized if the stock price is exactly at the strike price of the sold options at expiration.

Max Loss

The maximum loss is realized when the stock price moves significantly above the highest strike or below the lowest strike. It is calculated as the difference between the strike prices of the long and short calls or puts minus the net credit received. Here, the maximum loss would be:
$5 (difference between either the calls’ or puts’ strikes) - $6 (net credit) = $1 per share.

Risk

The risk is capped at the difference between the strike prices minus the credit received. The most important risk is from a large movement in the price of the underlying asset, but this is mitigated somewhat by the protective long call and put.

Time Decay

Time decay (theta) benefits the Iron Butterfly, especially as expiration approaches, provided the stock price remains near the strike price of the sold options. This erosion in time value increases the probability of retaining the premium received.

Implied Volatility

If the implied volatility is low after entering the position, it is a positive fact for the Iron Butterfly. As the volatility increases, the possibility of the stock price making a large move becomes low, thus increasing the chances of the sold options expiring worthless.

Conclusion

The Iron Butterfly is an awesome strategy to lock in stock prices that tend to stabilize within some narrow range and offers defined risks and profits: a controlled exposure to options market volatility.