What is an Iron Butterfly?
An iron butterfly is an options trade that uses four different contracts as part of a strategy to benefit from stocks or futures prices that move within a defined range. The trade is also constructed to benefit from a decline in implied volatility. The key to using this trade as part of a successful trading strategy is forecast a time when option prices are likely to decline in value generally. This usually occurs during periods of sideways movement or a mild upward trend. The trade is also known by the nickname "Iron Fly."
- Iron Butterfly trades are used as a way to profit from price movement in a narrow range during a period of declining implied volatility.
- The construction of the trade is similar to that of a short-straddle trade with a long call and long put option purchased for protection.
- Traders need to be mindful of commissions to be sure they can use this technique effectively in their own account.
- Traders need to be aware that his trade could lead to a trader acquiring the stock after expiration.
How an Iron Butterfly Works
The Iron Butterfly trade is created with four options consisting of two call options and two put options. These calls and puts are spread out over three strike prices, all with the same expiration date. The goal is to profit from conditions where the price remains fairly stable and the options demonstrate declining implied and historical volatility.
It can also be thought of as a combined option trade using both a short straddle and a long strangle, with the straddle positioned on the middle of the three strike prices and the strangle positioned on two additional strikes above and below the middle strike price.
The trade earns the maximum profit when the underlying asset closes exactly on the middle strike price on the close of expiration. A trader will construct an Iron Butterfly trade with the following steps.
- The trader first identifies a price at which they forecast the underlying asset will rest on a given day in the future. This is the target price.
- The trader will use options which expire at or near that day they forecast the target price.
- The trader buys one call option with a strike price well above the target price. This call option is expected to be out-of-the-money at the time of expiration. It will protect against a significant upward move in the underlying asset and cap any potential loss at a defined amount should the trade not go as forecast.
- The trader sells both a call and a put option using the strike price nearest the target price. This strike price will be lower than the call option purchased in the previous step and higher than the put option in the next step.
- The trader buys one put option with a strike price well below the target price. This put option is expected to be out-of-the-money at the time of expiration. It will protect against a significant downward move in the underlying asset and cap any potential loss at a defined amount should the trade not go as forecast.
The strike prices for the option contracts sold in steps two and three should be far enough apart to account for a range of movement in the underlying. This will allow the trader to be able to forecast a range of successful price movement as opposed to a narrow range near the target price.
For example, if the trader thinks that, over the next two weeks, the underlying could land at the price of $50, and be within a range of five dollars higher or five dollars lower from that target price, then that trader should sell a call and a put option with a strike price of $50, and should purchase a call option at least five dollars higher, and a put option at least five dollars lower, than the $50 target price. In theory, this creates a higher probability that the price action can land and remain in a profitable range on or near the day that the options expire.
Deconstructing the Iron Butterfly
The strategy has limited upside profit potential by design. It is a credit-spread strategy, meaning that the trader sells option premiums and takes in a credit for the value of the options at the beginning of the trade. The trader hopes that the value of the options will diminish and culminate in a significantly lesser value, or no value at all. The trader thus hopes to keep as much of the credit as possible.
The strategy has defined risk because the high and low strike options (the wings), protect against significant moves in either direction. It should be noted that commission costs are always a factor with this strategy since four options are involved. Traders will want to make certain that the maximum potential profit is not significantly eroded by the commissions charged by their broker.
The Iron butterfly trade profits as expiration day approaches if the price lands within a range near the center strike price. The center strike is the price where the trader sells both a call option and a put option (a short strangle). The trade diminishes in value as the price drifts away from the center strike, either higher or lower, and reaches a point of maximum loss as the price moves either below the lower strike price or above the higher strike price.
Iron Butterfly Trade Example
The following chart depicts a trade setup that implements an Iron Butterfly on IBM.
In this example the trader anticipates that the price of IBM shares will rise slightly over the next two weeks. The company released its earnings report two weeks previous and the reports were good. The trader believes that the implied volatility of the options will generally diminish in the coming two weeks, and that the share price will drift higher. Therefore the trader implements this trade by taking in an initial net credit of $550 ($5.50 per share). The trader will make a profit so long as the price of IBM shares moves in between 154.50 and 165.50.
If the price stays in that range on the day of expiration, or shortly before it, the trader can close the trade early for a profit. The trader does this by selling the call and put options that were previously purchased, and buying back the call and put options that were sold at the initiation of the trade. Most brokers allow this to be done with a single order.
An additional trading opportunity available to the trader occurs if the price stays below 160 on the day of expiration. At that time the trader can let the trade expire and have the shares of IBM (100 per put contract sold) put to them for the price of $160 per share.
For example, suppose the price of IBM closes at $158 per share on that day, and assuming the trader lets the options expire, the trader would then be obligated to buy the shares for $160. The other option contracts all expire worthless and the trader has no need to take any action. This may seem like the trader has simply made a purchase of stock at two dollars higher than necessary, but remember, the trader took in an initial credit of $5.50 per share. That means the net transaction can be seen differently. The trader was able to purchase shares of IBM and collect $2.50 profit per at the same time ($5.50 less $2.00).
Most of the effects of the Iron Butterfly trade can be accomplished in trades that require fewer options legs and therefore generate fewer commissions. These include selling a naked put or buying a put-calendar spread, however the Iron Butterfly provides inexpensive protection from sharp downward moves that the naked put does not have. The trade also benefits from declining implied volatility, which the put calendar spread cannot do.