You can think of this strategy as simultaneously running a short put spread and a short call spread with the spreads converging at strike B. Because it’s a combination of short spreads, an iron butterfly can be established for a net credit.
Ideally, you want all of the options in this spread to expire worthless, with the stock at strike B. However, the odds of this happening are fairly low, so you’ll probably have to pay something to close your position.
It is possible to put a directional bias on this trade. If strike B is higher than the stock price, this would be considered a bullish trade. If strike B is below the stock price, it would be a bearish trade.
NOTE: Strike prices are equidistant, and all options have the same expiration month.
Who Should Run It
Seasoned Veterans and higher
NOTE: Due to the narrow sweet spot and the fact you’re trading four different options in one strategy, long iron butterfly spreads may be better suited for more advanced option traders.
When to Run It
Typically, investors will use butterfly spreads when anticipating minimal movement on the stock within a specific time frame.
Break-even at Expiration
There are two break-even points for this play:
The Sweet Spot
You want the stock price to be exactly at strike B at expiration so all four options expire worthless.
Maximum Potential Profit
Potential profit is limited to the net credit received.
Maximum Potential Loss
Risk is limited to strike B minus strike A, minus the net credit received when establishing the position.
TradeKing Margin Requirement
NOTE: The net credit received from establishing the iron butterfly may be applied to the initial margin requirement.
Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
As Time Goes By
For this strategy, time decay is your friend. Ideally, you want all of the options in this spread to expire worthless with the stock precisely at strike B.
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast was correct and the stock price is at or around strike B, you want volatility to decrease. Your main concern is the two options you sold at strike B. A decrease in implied volatility will cause those near-the-money options to decrease in value. So the overall value of the butterfly will decrease, making it less expensive to close your position. In addition, you want the stock price to remain stable around strike B, and a decrease in implied volatility suggests that may be the case.
If your forecast was incorrect and the stock price is below strike A or above strike C, in general you want volatility to increase. This is especially true as expiration approaches. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike B. So the overall value of the iron butterfly will decrease, making it less expensive to close your position.
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