What is an Iron Butterfly?
Options provide several ways to generate money that are not available with traditional equities, and not all are high-risk activities. Theiron butterfly technique, for example, may create consistent income while reducing risks and rewards.
Because each strategy is named after a flying species such as a butterfly or condor, the iron butterfly approach belongs to a series of option strategies known as “wingspreads.” Combining a bear call spread with a bull put spread with the same expiry date that converges at a middle strike price yields the approach. A short call and put are both sold at the middle strike price, forming the butterfly’s “body,” while a call and put are bought above and below the middle strike price, respectively, to create the butterfly’s “wings.”
In two ways, this approach varies from the standard butterfly spread. First, it is a credit spread that pays a net premium to the investor at the open, while the standard butterfly position is a form of debit spread. Second, the technique requires four contracts rather than three.
- The iron butterfly approach is a credit spread in which four options are combined to reduce both risk and possible reward.
- The technique works best during times of minimal price volatility.
Assume ABC Company rose to $50 in August and the trader wishes to benefit on an iron butterfly. The trader writes a September 50 call and put for a $4.00 premium on each contract and also purchases a September 60 call and September 40 put for $0.75 apiece. The net outcome is an instant $650 credit after subtracting the price paid for the long bets from the premium obtained for the short positions ($800-$150).
- Short call and put premium received = $4.00 x 2 x 100 shares = $800
- Long call and put premium = $0.75 x 2 x 100 shares = $150
- $800 minus $150 equals $650 in first net premium credit.
How to Use the Iron Butterfly
Iron butterflies restrict both potential profits and losses. They are intended to enable traders to retain at least a part of the original net premium paid when the price of the underlying securities or index closes between the upper and lower strike prices. Market participants use this approach during periods of low volatility when they assume the underlying instrument will remain within a specified price range until the options expire.
Image by Sabrina Jiang © Investopedia2020
The larger the profit, the closer the underlying closes to the middle strike price at expiry. If the price closes above the strike price of the higher call or below the strike price of the lower put, the trader will lose money. By adding and subtracting the premium received from the middle strike price, the breakeven point may be calculated.
The breakeven points in the above example are computed as follows:
- Middle strike price = $50
- Net premium paid at the time of opening = $650
- Upper break-even point = $50 + $6.50 (multiplied by 100 shares = $650) = $56.50
- Lower break-even point = $50 minus $6.50 (multiplied by 100 shares = $650) = $43.50
If the price climbs above or below the breakeven thresholds, the trader will have to spend more to buy back the short call or put, resulting in a net loss.
Assume ABC Company closes at $75 in November, which indicates that all of the options in the spread, save the call options, will expire worthless. To close out the position, the trader must buy back the short $50 call for $2,500 ($75 market price minus $50 strike price x 100 shares) and gets paid a matching premium of $1,500 on the $60 call ($75 market price – $60 strike price = $15 x 100 shares). The net loss on the calls is therefore $1,000, which is reduced from the original net premium of $650 to provide a final net loss of $350.
Of fact, the upper and lower strike prices do not have to be equidistant from the center strike price. Iron butterflies may be generated with a bias in either way, where the trader feels the underlying asset’s price will climb or decrease somewhat but only to a particular amount. If the trader feels ABC Company will climb to $60 before expiry, they may adjust the higher call or lower put strike prices appropriately.
Iron butterflies may also be inverted, with long bets taken at the center strike price and short ones taken at the wings. During moments of high volatility in the underlying instrument, this may be done advantageously.
Advantages and Disadvantages
Iron butterflies have numerous important advantages. They may be produced with a little amount of cash and generate more consistent income with less risk than directional spreads. If the price starts to move out of the range, they may be rolled up or down like any other spread, or traders can opt to close out half of the position and profit on the remaining bear call or bull put spread. The criteria for risk and return are likewise well specified. The net premium paid is the greatest potential profit the trader can make from this strategy, while the difference between the net loss of the long and short calls or puts minus the original premium paid represents the maximum possible loss the trader may suffer.
On iron butterflies, keep an eye on commission costs since four positions must be started and closed, and the full profit is seldom obtained because the underlying will normally settle between the middle strike price and either the higher or lower limit. Furthermore, the odds of losing money are correspondingly larger since most iron butterflies are made with rather small spreads.
The Bottom Line
Iron butterflies are intended to deliver consistent revenue to traders and investors while minimising risk. This sort of approach, however, is only acceptable after a comprehensive knowledge of the prospective risks and benefits. Most brokerage platforms additionally demand that customers who use this or similar techniques fulfill specific skill and financial standards.
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