Options provide investors with ways to make money that cannot be duplicated with conventional securities such as stocks or bonds. And not all types of option trading are high risk ventures; there are many ways to limit potential losses. One of these is by using an iron butterfly strategy that sets a definite dollar limit on the amounts that the investor can either gain or lose. It's not as complex as it sounds.

What Is An Iron Butterfly?

The iron butterfly strategy is a member of a specific group of option strategies known as “wingspreads” because each strategy is named after a flying creature such as a butterfly or condor. The iron butterfly strategy is created by combining a bear call spread with a bull put spread with an identical expiration date that converges at a middle strike price. A short call and put are both sold at the middle strike price, which forms the “body” of the butterfly, and a call and put are purchased above and below the middle strike price respectively to form the “wings”. This strategy differs from the basic butterfly spread in two respects; it is a credit spread that pays the investor a net premium at open, whereas the basic butterfly position is a type of debit spread, and it requires four contracts instead of three like its generic cousin.

Example

ABC Company is trading at $50 in August. Eric wants to use an iron butterfly to profit on this stock. He writes both a September 50 call and put and receives $4.00 of premium for each contract. He also buys a September 60 call and September 40 put for $0.75 each. The net result is an immediate $650 credit after the price paid for the long positions is subtracted from the premium received for the short ones ($800-$150).

Premium received for short call and put = $4.00 x 2 x 100 shares = $800

Premium paid for long call and put = $0.75 x 2 x 100 shares = $150

$800 - $150 = $650 initial net premium credit

How The Strategy Is Used

As mentioned previously, iron butterflies limit both the possible gain and loss for the investor. They are designed to allow investors to keep at least a portion of the net premium that is initially paid, which happens when the price of the underlying security or index closes between the upper and lower strike prices. Investors will therefore use this strategy when they believe that the underlying instrument will stay within a given price range through the options’ expiration date. The closer the underlying instrument closes to the middle strike price, the higher the investor’s profit. Investors will realize a loss if the price closes either above the strike price of the upper call or below the strike price of the lower put. The break-even point for the investor can be determined by adding and subtracting the premium received from the middle strike price. Building on the previous example, Eric’s break-even points are calculated as follows:

Middle strike price = $50

Net premium paid upon open = $650

Upper break-even point = $50 + $6.50 (x 100 shares = $650) = $56.50

Lower break-even point = $50 - $6.50 (x 100 shares = $650) = $43.50

If the price rises above or below the break-even points, then Eric will pay more to buy back the short call or put than he received initially, resulting in a net loss.

Example

ABC Company closes at $75 in November, which means that all of the options in the spread will expire worthless except for the call options. Eric must therefore buy back the short $50 call for $2,500 ($75 market price - $50 strike price x 100 shares) in order to close out his position and is paid a corresponding premium of $1,500 on the $60 call he purchased ($75 market price - $60 strike price = $15 x 100 shares). His net loss on the calls is therefore $1,000, which is then subtracted from his initial net premium of $650 for a final net loss of $350.

Of course, it is not necessary for the upper and lower strike prices to be equidistant from the middle strike price. Iron butterflies can be created with a bias in one direction or the other, where the investor may believe that they stock may rise or fall slightly in price, but only to a certain level. If Eric believed that ABC Company might rise to $60 by expiry in the above example, then he could raise or lower the upper call or lower put strike prices accordingly.

Iron butterflies can also be inverted so that the long positions are taken at the middle strike price and the short positions are placed at the wings. This can be done profitably during periods of high volatility for the underlying instrument.

Advantages and Disadvantages

Iron butterflies provide several key benefits for traders. They can be created using a relatively small amount of capital and provide steady income with less risk than directional spreads for those who use them on securities that close within the spread price. They can also be rolled up or down like any other spread if the price begins to move out of this range, and investors can close out half of the trade and profit on the remaining bear call or bull put spread if they so choose. Their risk and reward parameters are also clearly defined. The net premium paid at open is the maximum possible profit that the investor can reap from this strategy, and the difference between the net loss reaped between the long and short calls or puts minus the initial premium paid is the maximum possible loss that the investor can incur as shown in the example above.

But investors need to watch their commission costs for this type of trade as four separate positions must be opened and closed, and the maximum possible profit is seldom earned here because the underlying instrument will usually close somewhere between the middle strike price and either the upper or lower limit. And because most iron butterflies are created using fairly narrow spreads, the chances of incurring a loss are proportionately higher.

The Bottom Line

Iron butterflies are designed to provide investors with steady income while limiting their risk. However, this type of strategy is generally only appropriate for experienced option traders who can watch the markets during trading hours and thoroughly understand the potential risks and rewards involved. Most brokerage and investment platforms also require investors who employ this or other similar strategies to meet certain financial or trading requirements.

Related Articles
  1. Options & Futures

    The Butterfly Spread

    A butterfly spread is a neutral options strategy with both limited risk and limited profit potential. The strategy involves four options contracts with the same expiration month but with three ...
  2. Trading Strategies

    Adjusting A Long Call Into A Butterfly Spread

    There are many key advantages offered to options traders who deal only in the underlying securities.
  3. Options & Futures

    Advanced Option Trading: The Modified Butterfly Spread

    This strategy provides traders with the flexibility to craft a position with unique risk/reward characteristics.
  4. Options & Futures

    Setting Profit Traps With Butterfly Spreads

    The OTM butterfly spread offers traders three unique advantages, and can lead to consistent profits. Find out how.
  5. Options & Futures

    How To Sell Put Options To Benefit In Any Market

    Selling a put option is a prudent way to generate additional portfolio income and gain exposure to desired stocks while limiting your capital investment.
  6. Options & Futures

    How To Buy Oil Options

    Crude oil options are the most widely traded energy derivative in the New York Mercantile Exchange.
  7. Retirement

    Roth IRAs Tutorial

    This comprehensive guide goes through what a Roth IRA is and how to set one up, contribute to it and withdraw from it.
  8. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  9. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  10. Options & Futures

    Five Advantages of Futures Over Options

    Futures have a number of advantages over options such as fixed upfront trading costs, lack of time decay and liquidity.
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  3. Can hedge funds outperform the market?

    Generating returns that exceed those provided by the broader market is the goal of nearly every investor. However, the methods ... Read Full Answer >>
  4. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  5. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  6. How does a forward contract differ from a call option? (AAPL)

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
Hot Definitions
  1. Short Selling

    Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is ...
  2. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  3. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  4. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  5. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  6. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center