What is an iron butterfly?
Options provide many money-making strategies that cannot be replicated with traditional securities, and not all of them are high-risk investments. For example, the iron butterfly strategy can generate stable income while limiting risks and profits.
The Iron Butterfly strategy is a member of a group of option strategies called “wingspan”, because each strategy is named after a flying creature such as a butterfly or a condor. This strategy is created by combining a bear market call option spread with a bull market put option spread with the same expiration date, and the spread converges to the mid-strike price. Both short call options and put options are sold at the intermediate strike price to form the “body” of the butterfly. Call options and put options are bought above and below the intermediate strike price to form “wings”.
This strategy differs from the basic butterfly spread in two respects. First, it is a credit spread that pays investors a net premium at the opening of the market, while a basic butterfly position is a debit spread. Second, the strategy requires four contracts instead of three.
- The iron butterfly strategy is a credit spread, involving a combination of four options, which limits both risk and potential profit.
- This strategy is most suitable for use during periods of low price volatility.
For example, suppose ABC Co. rises to $50 in August, and a trader wants to use the iron butterfly to generate profit. The trader wrote down the call options and put options on September 50 at the same time. Each contract received a premium of $4.00. He also bought 60 call options on September and $0.75 each on September 40 put options. After subtracting the price paid for the long position from the premium received for the short position ($800-150), the net result is an immediate credit of $650.
- Premium of short call and put options = $4.00 x 2 x 100 shares = $800
- Premium paid for long-term call and put options = US$0.75 x 2 x 100 shares = US$150
- $800-$150 = $650 initial net premium credit
How to use iron butterfly
The iron butterfly limits the possible gains and losses. They are designed to allow traders to retain at least a portion of the net premium originally paid, which occurs when the price of the underlying security or index closes between the upper and lower strike prices. Market participants use this strategy when volatility is low, when they believe that the underlying instrument will remain within a given price range before the expiry date of the option.
The closer the closing price of the subject matter at maturity is to the intermediate execution price, the higher the profit. If the closing price is higher than the exercise price of the call option or lower than the exercise price of the put option, the trader will suffer a loss. The break-even point can be determined by adding and subtracting the premium received from the intermediate execution price.
In the previous example, the break-even point is calculated as follows:
- Intermediate execution price = 50 USD
- Net premium paid at market opening = $650
- Upper limit of break-even point = US$50 + US$6.50 (x 100 shares = US$650) = US$56.50
- Lower break-even point = US$50-US$6.50 (x 100 shares = US$650) = US$43.50
If the price rises above or below the break-even point, the trader will pay more short call or put options than initially received, resulting in a net loss.
Assuming that ABC Company closed at $75 in November, this means that all options in the spread will be worthless except for call options. Therefore, the trader must repurchase a short US$50 call option at a price of US$2,500 (US$75 market price minus US$50 strike price x 100 shares) in order to close the position, and trade the US$60 call option (US$75 market price-US$60) (Strike price) paid on the corresponding premium price of $1,500 = $15 x 100 shares). Therefore, the net loss of the call option is $1,000, which is then subtracted from the initial net premium of $650, resulting in a final net loss of $350.
Of course, the distance between the upper and lower execution price and the intermediate execution price need not be equal. The iron butterfly can produce deviations in one direction or the other. Traders believe that the price of the underlying asset will rise or fall slightly, but only to a certain level. If traders believe that ABC Company will rise to $60 before expiration, they can increase or decrease the upper limit of the call option or the strike price of the put option accordingly.
Iron Butterfly can also be inverted so that long positions are carried out at the mid-strike price and short positions are placed on the wings. This can be profitable during periods of high volatility in the underlying instrument.
Pros and cons
The iron butterfly provides several key benefits. They can be created with relatively little capital and provide stable income with less risk than targeted spreads. If prices start to go out of range, they can also roll up or down like any other spread, or the trader can choose to close half of the position and take advantage of the remaining bear market call option or bull market put option spread. The risk and return parameters are also clearly defined. The net premium paid is the maximum possible profit that a trader can obtain from the strategy. The net loss of long and short call or put options minus the initial premium paid is the maximum possible loss that the trader may suffer.
Observe the commission cost of the iron butterfly, because four positions must be opened and closed, and the maximum profit is rarely obtained, because the subject matter is usually settled between the intermediate execution price and the upper or lower limit. In addition, the chances of loss are correspondingly higher, because most iron butterflies are created with fairly narrow spreads.
Iron Butterfly aims to provide traders and investors with stable income while limiting risks. However, this strategy is only appropriate after a thorough understanding of the potential risks and rewards. Most brokerage platforms also require clients who adopt this or similar strategies to meet certain skill levels and financial requirements.