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:
- 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 at-the-money put with a strike price equal or near the current cost of the underlying asset.
- Sell one at-the-money call having a strike price equal or near the current price of the underlying asset.
- 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.
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.