What to Know About the Iron Butterfly Options Strategy

Breaking down iron butterfly spreads with Bernie Schaeffer

Apr 13, 2022 at 10:03 AM
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    All week, we've been unpacking options strategies with cool names. Next up, the iron butterfly is a flexible options strategy that can be placed using call or put options, but each trade's risk and reward parameters are unique to the options being used. Entering iron butterflies is a popular strategy among conservative traders who want to reduce risk on their trades but still generate decent returns.

    Iron butterflies offer an excellent strategy for managing risk with limited profits. They are also widely considered to provide low-risk trade opportunities that give the traders defined reward limits to move the price out of the trading range.

    What is the Iron Butterfly Options Strategy?

    The iron butterfly strategy is a member of the option trading strategies family known as "wingspan" strategies. These are more complex than simply buying or selling call or put options, but they can be more profitable if used properly. The iron butterfly is one of the most popular techniques for experienced traders. It combines buying and selling call and put options simultaneously with different strike prices to create a "winged" position that benefits from flat or slightly volatile markets.

    The strategy has a limited risk because all option legs are covered by cash or other securities. In addition, there is no margin requirement because nothing is sold short. The income generated by selling options is reduced by buying other options, but it can still be a profitable strategy if used properly. In addition, there is no margin requirement because nothing is sold short. The income generated by selling options is reduced by buying other options, but it can still be a profitable strategy if used properly.

    The Iron Butterfly trading strategy combines a Bull Put Spread and a Bear Call Spread with the same expiration date. This gives you a risk graph that resembles a butterfly. The Iron Butterfly is used when an options trader expects the underlying security to trade within a specific price range. The Iron Butterfly can be created using both Calls and Puts, but this article will only focus on the Call version of the trade.

    The iron butterfly is created by buying a put with a strike price below the current price, selling a put with a lower strike price and the same expiration, buying a call with a strike price above the current market price, and selling a call with a higher strike price and the same expiration. The maximum profit is limited to the difference between the two strikes minus the net debit paid for the position.

    The iron butterfly may be entered as either a debit or credit spread. For example, suppose XYZ stock is currently trading at $100 per share. In that case, an investor might buy an OTM put option expiring in six months at $90 while at the same time selling an OTM put option expiring in six months at $80. Next, they would buy an OTM call option expiring in six months at $110 while at the same time selling an OTM call option expiring in six months at $120. If XYZ stock is trading below $90 or above $110 upon expiration, all options will expire worthlessly. If XYZ stock is trading between $80 and $120 upon expiration, both sold options will be exercised, resulting in no net gain or loss on the position.

    What are the Advantages?

    The most significant advantage of the iron butterfly is that it is a low-risk, limited reward strategy. This makes it a perfect option trading strategy for risk-averse traders who do not want to use too much margin in their accounts. It is also straightforward to set up and understand, making it even more appealing for many traders.

    There are three main ways in which iron butterflies provide an advantage over other strategies:

    Low Risk: Iron butterflies are constructed as credit spreads, meaning that they can make money as long as the price stays within a specific range. While this also limits the maximum profit potential, there is a high probability of success, especially compared to other strategies.

    Limited Profit Potential: The maximum profit from an iron butterfly is limited to the net premium from entering the trade, but there is no limit to how much a trader can lose. This makes iron butterflies very attractive for those who want to reduce their exposure while still taking advantage of opportunities in the market.

    Defined Risk/Reward Parameters: The maximum risk for an iron butterfly is capped at its entry price minus the premium received, while its maximum reward is limited by its initial debit

    When Should You Apply the Iron Butterfly Options Strategy?

    A trader might use this strategy when neutral about the market but expecting volatility in the underlying asset. For example, if a stock has been trading in a narrow range for weeks or months but has recently made daily moves of several points in either direction, it might be suitable for an iron butterfly strategy.

    If the stock price at expiration is between the two short strikes, then one long leg will be exercised, and one short leg will be assigned, resulting in a maximum loss for the trader. This can be calculated by adding the debit paid for both long legs and subtracting the credit received for both short legs.

    The iron butterfly can also experience a partial loss if the stock price at expiration is between its long and short strikes. In this case, only one long leg and one short leg will expire worthless while another long leg will be exercised, and another short portion will be assigned, resulting in a partial loss for the trader.

    It's important to note that not all iron butterfly strategies are created equal. The strategy has numerous variations, and the exact design depends on the trader's risk tolerance, market outlook, and other factors.

    For example, an iron butterfly can be designed to return a profit if the underlying security remains between the middle strike price and either wing. Conversely, iron butterflies make money when the underlying security moves out of this range and into either wing. The iron butterfly strategy is typically created using stock options, but it can also be established with index options, ETF options, or options on futures.

     

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