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.

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