What is an Iron Butterfly?
Options trading provides a host of opportunities to investors. Furthermore, Options strategies involve executing more than one option position simultaneously to minimize the risk and maximize returns. Iron butterfly is one of the many option trading strategies.
Iron Butterfly Options Strategy?
Iron Butterfly Options Strategy is a subset of a group of trading strategies called ‘wingspreads’. Iron Butterfly is a combination of the iron condor and butterfly strategy. The iron butterfly strategy aims to create a market-neutral strategy by combing call and put options with identical expiration dates which consolidate at a middle strike price. Iron Butterfly involves writing a call and putting an option at the middle strike price forming the ‘body’ of the butterfly. At the same time, call and put options are purchased above and below the strike price respectively to form the ‘wings’.
The iron butterfly strategy can be better understood with the help of an example –
Let’s suppose the shares of X & Y Co. are trading at Rs. 100 in September. To use the iron butterfly options strategy, the trader writes call and put options at a strike price of Rs. 100, both expiring in October. The premium earned from writing the options is Rs. 45. Concurrently, the trader also buys a call and put option at the strike price of Rs. 105 and Rs. 95 respectively. The premium paid is Rs. 6. The difference between the premium earned and paid is an immediate gain for the trader i.e., Rs. 39.
In the above example, let’s suppose the shares of X & Y Co. are valued at Rs. 100 in October. In this case, each option expires worthless, and the profit earned is Rs. 39. The maximum profit in the iron butterfly is made in case the security closes at the middle strike price.
Alternatively, let’s assume the X & Y Co. shares close at Rs. 102. In this case, both put options expire worthlessly. While the call option bought expires worthless, a net loss is incurred in the call option sold of Rs. 2. Thus, the overall profit is reduced to Rs. 37.
How does Iron Butterfly Strategy work?
Iron butterfly options profits are assured if the price of the security moves in a certain range. Effectively, the trader makes a profit unless the price of the security closes below the lower strike price or above the higher strike price. In this case, the trader profits if the security closes in the range of Rs. 95 to Rs. 105 and the maximum profit is at Rs. 100.
The breakeven point for iron butterflies is by adding and subtracting the net premium received from the middle price.
Upper Breakeven Point = Middle Price + Net Premium Earned = Rs. 100 + Rs. 39 = Rs. 139
Bottom Breakeven Point = Middle Price – Net Premium Earned = Rs. 100 – Rs. 39 = Rs. 61
If the closing price of the security crosses either the upper or the lower breakeven point, then the trader incurs a loss. The trader will have to pay more than the net premium earned to square off the options sold.
Having understood the meaning of the iron butterfly, let’s discuss the various scenarios in which the iron butterfly may be applied.
Deconstructing Iron Butterfly
Iron Butterfly Options Strategy is deployed when market volatility is comparatively lower. When the volatility is higher, the likelihood of the prices trading in a range is lower. Thus, the iron strategy is not to be applied in volatile security. If the price of the security does not tend to fluctuate significantly, the iron butterfly provides regular income. At the same time, the capital commitment for iron butterflies is lower than other strategies which provide steady income.
The objective of the iron butterfly is to earn moderate returns at low-risk levels. Iron butterfly caps the maximum profit and loss from trade and the risk and reward are predefined. Iron butterfly is designed such that at least a part of the initial gain from the writing and buying options is retained by the trader if the security trades between the upper and lower strike prices. Thus, the probability of incurring a loss is relatively higher since most iron butterfly strategies are created with narrow spreads. The sweet spot for iron butterflies is quite narrow and so this strategy is suitable for experienced traders and veterans.