What is an 'Iron Butterfly'

An iron butterfly is a short options strategy created with four options consisting of two puts and two calls, and three strike prices, all with the same expiration date. Its goal is to profit from low volatility in the underlying asset. In other words, it earns the maximum profit when the underlying asset closes at the middle strike price at expiration. 

The strategy has limited upside and downside risk because the high and low strike options, the wings, protect against significant moves in either direction. Because of this limited risk, its profit potential is also limited. The commission can be a notable factor here, as there are four options involved.

BREAKING DOWN 'Iron Butterfly'

An iron butterfly is a combination of strategies. Ideally, the trader would like all of the options to expire worthlessly, which is only possible if the underlying asset closes precisely at the middle strike price at expiration. There will likely be a fee to close the trade if it is successful. If it is not successful, the loss is still limited.

The construction of the strategy is as follows:

  1. Buy one out-of-the-money put with a strike price below the current price of the underlying asset. The out-of-the-money put option will protect against a significant downside move to the underlying asset. 
  2. Sell one at-the-money put with a strike price equal or near the current cost of the underlying asset.
  3. Sell one at-the-money call having a strike price equal or near the current price of the underlying asset.
  4. Buy one out-of-the-money call with a strike price above the current price of the underlying asset. The out-of-the-money call will protect against a substantial upside move.

The out-of-the-money options, called the wings, are both long positions. Because both of these options are out-of-the-money, their premiums are lower than the two at-the-money options written, so there is a net credit to the account when placing the trade. Further, by selecting different strike prices, it is possible to make the strategy lean bullish or bearish. For example, if the middle strike price is above the current price of the underlying asset, the trader hopes for a small rise in its price by expiration. It still has limited reward and limited risk.

Deconstructing the Butterfly

Two different option combinations will produce the same results. The first version is as a combination of a bull put spread and a bear call spread. Here, the strike price of the bull put, the higher option, and the bear call, the lower option, is the same.

Alternatively, the two at-the-money options start with a short straddle, which involves selling a put and a call with the same at-the-money strike and expiration. It then adds a long strangle to create the wings, buying both the out-of-the-money call and put.

A chart showing an iron butterfly option

The iron butterfly strategy differs from a butterfly spread because it uses both calls and puts, as opposed to all calls or all puts. A trader's maximum profit is equal to the net premium received, after commissions, if the underlying asset closes exactly at the center strike price. Their maximum loss is the difference in strike prices for the calls, or put options, minus the net credit received after paying commissions.

RELATED TERMS
  1. Butterfly Spread

    Butterfly spreads are a neutral option strategy, used to profit ...
  2. Bull Put Spread

    A type of options strategy that is used when the investor expects ...
  3. Wingspread

    To maximize potential returns for certain levels of risk (while ...
  4. Bull Spread

    A bull spread is a bullish options strategy using either two ...
  5. Bear Call Spread

    A bear call spread is a bearish options strategy used to profit ...
  6. Currency Option

    A contract that grants the holder the right, but not the obligation, ...
Related Articles
  1. Trading

    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

    What is an Iron Butterfly Option Strategy?

    The iron butterfly options play can generate profits for market players who believe there will be minimal price movement until expiration.
  3. Trading

    Using Options To Pay Off Debt

    We tell you about four option strategies that could provide a way to pay off your debt.
  4. Trading

    Profiting From Stock Declines: Bear Put Spread Vs. Long Put

    If you're bearish, you should compare the risk/reward characteristics of these two strategies.
  5. Trading

    Strategies for Trading Volatility With Options (NFLX)

    These five strategies are used by traders to capitalize on stocks or securities that exhibit high volatility.
  6. Trading

    Options Strategies for Your Portfolio to Make Money Regularly

    Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums.
  7. Trading

    Bear Put Spreads: An Alternative to Short Selling

    This strategy allows you to stop chasing losses when you're feeling bearish.
  8. Trading

    The Basics of Options Profitability

    Learn the various ways traders make money with options, and how it works.
  9. Trading

    Options Trading: The Modidor Spread

    Use this modification of an iron condor to reduce risk and increase your chance at profiting on the trade.
RELATED FAQS
  1. How do I set a strike price for an option?

    Learn about the strike price of an option and how to set a strike price for call and put options depending on risk tolerance ... Read Answer >>
  2. What is the difference between in the money and out of the money?

    Learn how the difference between in the money and out of the money options is determined by the relationship between strike ... Read Answer >>
Hot Definitions
  1. Investment Advisor

    An investment advisor is any person or group that makes investment recommendations or conducts securities analysis in return ...
  2. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  3. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  4. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  5. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  6. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
Trading Center