What is an Iron Butterfly?
Options offer many strategies to make money that cannot be duplicated with conventional securities and not all are high-risk ventures. For example, the iron butterfly strategy can generate steady income while limiting risks and profits.
The iron butterfly strategy is a member of a group of option strategies known as “wingspreads” because each strategy is named after a flying creature like a butterfly or condor. The 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. First, it is a credit spread that pays the investor a net premium at open while the basic butterfly position is a type of debit spread. Second, the strategy requires four contracts instead of three.
- The iron butterfly strategy is a credit spread that involves combining four options, which limits both risk and potential profit.
- The strategy is best employed during periods of lower price volatility.
For example, let's say ABC Co. rallied to $50 in August and the trader wants to use an iron butterfly to generate profits. He or she writes both a September 50 call and put, receiving a $4.00 premium for each contract, and 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 to Use the Iron Butterfly
Iron butterflies limit both possible gains and losses. They are designed to allow traders 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. Market players use this strategy during times of lower volatility, when they believe the underlying instrument will stay within a given price range through the options’ expiration date.
The nearer to the middle strike price the underlying closes at expiration, the higher the profit. The trader will incur 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 breakeven point can be determined by adding and subtracting the premium received from the middle strike price.
In the previous example, the breakeven 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 breakeven points, the trader will pay more to buy back the short call or put than received initially, resulting in a net loss.
Let's say ABC Company closes at $75 in November, which means all of the options in the spread will expire worthless except for the call options. The trader must therefore buy back the short $50 call for $2,500 ($75 market price minus $50 strike price x 100 shares) in order to close out the position and is paid a corresponding premium of $1,500 on the $60 call ($75 market price - $60 strike price = $15 x 100 shares). The net loss on the calls is, therefore, $1,000, which is then subtracted from the 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 trader believes the underlying asset will rise or fall slightly in price but only to a certain level. If the trader believes ABC Company will rise to $60 by expiration, they can raise or lower the upper call or lower put strike prices accordingly.
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.
Advantages and Disadvantages
Iron butterflies provide several key benefits. They can be created using a relatively small amount of capital and provide steady income with less risk than directional spreads. They can also be rolled up or down like any other spread if price begins to move out of the range or traders can choose to close out half of the position and profit on the remaining bear call or bull put spread. The risk and reward parameters are also clearly defined. The net premium paid is the maximum possible profit the trader can reap from this strategy and the difference between the net loss between the long and short calls or puts minus the initial premium paid is the maximum possible loss the trader can incur.
Watch commission costs on iron butterflies because four positions must be opened and closed, and the maximum profit is seldom earned because the underlying will usually settle between the middle strike price and either the upper or lower limit. In addition, the chances of incurring a loss are proportionately higher because most iron butterflies are created using fairly narrow spreads.
The Bottom Line
Iron butterflies are designed to provide traders and investors with steady income while limiting risk. However, this type of strategy is only appropriate after thoroughly understanding the potential risks and rewards. Most brokerage platforms also require clients who employ this or similar strategies to meet certain skill levels and financial requirements.