Reverse Iron Butterfly

The Reverse Iron Butterfly Setup

Suppose you were looking at the stock, XYZ, trading for $100. To set up a Reverse Iron Butterfly, you would:

1. Buy an at-the-money call and an at-the-money put both with a strike price of $100.
2. Sell an out-of-the-money call and an out-of-the-money put. In this case, sell a call with a strike price of $110 and sell a put with a strike price of $90.

The long premiums are netted against the short premiums received, and normally this results in a net debit, or cost, to enter the trade.

Who Should Consider It

This strategy is suitable for experienced traders who can expect the significant movement of the price of the underlying asset but are unsure which direction it will take. It is really very appealing in high volatility periods or before main market events like announcements of earnings or dissemination of economic data.

Strategy Explained

The Reverse Iron Butterfly aims to profit from significant price moves either up or down. Ideally, the profit from the long call or long put will exceed the loss from the short call or short put, respectively, as the stock makes a large move away from the strike price.

Breakeven Process

There are two breakeven points for this strategy:

• Upper breakeven: Higher strike of the call + net debit paid.
• Lower breakeven: Lower strike of the put - net debit paid.

Using the XYZ example, if the net debit is $5:

• Upper breakeven = $110 + $5 = $115.
• Lower breakeven = $90 - $5 = $85.

Sweet Spot

The sweet spot for this strategy is when the stock price moves significantly beyond either breakeven point. The more dramatic the price movement, the greater the potential profit.

Max Profit Potential

Theoretically, the profit is unlimited in the case where the stock price goes beyond the upper breakeven point or falls below the lower breakeven point, as one of the long options will gain value faster than the loss accruing from the other positions.

Max Loss

The maximum loss is capped and occurs when the stock price is precisely at the strike price of the long options at expiration. The maximum loss is equal to the initial net debit paid to establish the position.

Risk

Main risk: The stock does not move enough, and the position incurs the maximum loss-the net debit paid. The strategy requires significant price movement to overcome the costs associated with the setup.

Time Decay

The decay in time, or Theta, is also important because it could erode the value of long positions much faster than that of short positions. In addition, when time approaches expiration and the stock price stays near the strike price of long options, the rate of decay in time will be very high, leading to potential losses.

Implied Volatility

Changes in implied volatility can result in a mixed impact. This is because rising volatility increases the value of long options, whereas an increase in the value of short options has the potential to dilute a few of those benefits. More often than not, traders opt for this strategy when they predict an increase in volatility.

Conclusion

The Reverse Iron Butterfly is a complex strategy best suited for volatile markets where significant price moves are expected. It offers well-defined risk and the potential for substantial profit, but requires careful management and an understanding of both directional and volatility factors.