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 sideways or slowly upward. The key to succeeding in the strategy is to position the four contracts properly so that the risk of loss is low and the likelihood of small but consistent profits is high.
- Iron Condor trades are an option strategy to profit from a sideways moving market.
- Traders expect to make smaller profits when they win and larger losses when they lose.
- Traders expect to win this trade more often than they lose.
- Traders need to be mindful of commissions to be sure they can trade this strategy correctly.
How an Iron Butterfly Works
The iron butterfly trade is a combination of two vertical-spread trades—a bull put spread and a bull call spread. The trade is a credit-spread options strategy created with four options consisting of two puts and two calls, and four 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 in between the two middle strike prices at expiration.
The construction of the strategy is as follows:
- 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.
- Sell one out-of-the-money put with a strike price below the current price, but nearer to it than the put option bought in step one.
- Sell one out-of-the-money call having a strike price above the current price of the underlying asset.
- Buy one out-of-the-money call with a strike price further above the current price of the underlying asset than the call sold in step three. The out-of-the-money call will protect against a substantial upside move.
The strike prices for the option contracts sold in steps two and three should be far enough apart to account for the likely move of the underlying during the time between trade entry and expiration.
For example, if the trader thinks the underlying could move $6 in the next two weeks, then the strike price for the short call option (in step 3) should be at least $5 higher than the current price of the underlying. The short put option (in step 2) should be at least $5 lower than the current price of the underlying. In theory, this will allow a high probability that the price action will stay in between the two inner strike prices
The strategy has limited upside profit potential by design. Iron-condor traders expect to win relatively small amounts from their trades on a consistent basis and to win more often than they lose. The strategy has limited downside risk because the high and low strike options (the wings), protect against significant moves in either direction, but in comparison to the amount of money gained on each trade, the potential maximum loss is greater than the potential maximum gain.
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.
Deconstructing the Iron Condor
Two different option combinations combine to produce the results of the Iron Condor trade. The first is a combination of a long and a short put option resulting bull put spread, a credit spread which collects and keeps profit so long as the price of the underlying remains above the higher of the two strikes (depicted as 1 and 2 in the figure below).
The second is a combination of a long and short call option resulting in a bear call spread. This credit spread collects and keeps profit so long as the price of the underlying remains below the lower of the two strikes (depicted as 3 and 4 in the figure below).
This figure depicts how the iron condor's profit/loss profile plays out at expiration. If the underlying is between strike prices 2 and 3, the maximum profit is achieved. If the price of the underlying is above strike 4 or below strike 1, the maximum loss is taken.