The iron butterfly is an advanced strategy that employs four option contracts at three different strikes. The trade is composed of two sold options -- one call and one put -- at the center strike, with a purchased call and a purchased put at the upper and lower strikes, respectively.
In other words, the iron butterfly is the combination of a short call spread and a short put spread, with the two sold options overlapping at the focus strike. Alternately, you could consider this strategy to be a hedged version of the short straddle, since that strategy -- like the iron butterfly -- allows for considerably less wiggle room in the price action of the underlying than a short put spread or short call spread. In fact, the best outcome is for the shares to remain completely lifeless through expiration.
To understand how the iron butterfly works, let's dissect an example.
Stock XYZ is pinned at $70, and you expect the shares to remain stuck through the next month. To capitalize on this stagnation, you initiate an iron butterfly. You sell to open a 70-strike call for the bid price of 1.45 and buy to open a 72.50-strike call for the ask price of 0.54, while simultaneously selling to open a 70-strike put for the bid price of 1.76 and buying to open a 67.50-strike put for the ask price of 0.86.
You collected 3.21 (1.45 + 1.76) from the sale of the two short options, and spent 1.40 (0.54 + 0.86) to purchase the two long options. Subtracting your debits of 1.40 from your credits of 3.21, you're looking at a net credit of 1.81 to enter the trade. Multiplied by 100 shares per contract, that's $181 in your pocket at initiation.
The best-case scenario is for XYZ to finish squarely at $70 upon expiration. In this case, all of the options involved can be left to expire worthless, and you'll walk away with the maximum potential profit -- which is your initial net credit of $181.
There are two breakeven points on the iron butterfly. On a move higher, it's equivalent to the focus strike plus the net credit -- in this example, 70 + 1.81 = 71.81. On a move lower, it's the focus strike less the net credit, or 70 - 1.81 = 68.19. In other words, you won't begin to take losses on your options until XYZ trades above $71.81 or below $68.19.
Once the stock breaches one of those breakeven rails, losses will start to mount. However, since you've purchased options at the two outer strikes, your potential risk is limited. If the stock drops, the most you can lose is limited to the difference between the two put strikes, less the net credit -- [(70 - 67.50) - 1.81]. If XYZ rallies, your maximum loss is equal to the difference between the two call strikes, less the net credit -- [(72.50 - 70) - 1.81]. Since the strikes are equidistant in a traditional iron butterfly, that adds up to 0.69, or $0.69, in both cases.
However, bear in mind that you'll need to take action to close out your short options if one of them moves into the money by expiration.
Since you sold two at-the-money options, declining implied volatility is generally a good thing for the iron butterfly trader. All other things being equal, this will reduce the value of your sold options, making them cheaper to buy back if need be. Of course, since you also bought two options, the value of those contracts will also take a hit if volatility declines.
Like the short straddle, the iron butterfly requires both nerves of steel and a high level of confidence in your technical forecast for the stock. Before entering the trade, be sure you've reviewed the corporate calendar to ensure there are no major events looming that could spark a major move in the stock.
Meanwhile, like the iron condor, the iron butterfly carries fairly high administrative expenses. Since the trade involves four separate opening transactions, along with the potential for closing transactions, brokerage costs can add up quickly. With the profit on this trade strictly capped, be careful that your brokerage expenses don't outweigh your potential reward.