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Iron Butterfly

Options Playbook

The Strategy

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.

Options Guy's Tips

Since an iron butterfly is a “four-legged” spread, the commissions typically cost more than a long butterfly . That causes some investors to opt for the long butterfly instead.

Some investors may wish to run this strategy using index options rather than options on individual stocks. That’s because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index’s component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.

The Setup

  • Buy a put, strike price A
  • Sell a put, strike price B
  • Sell a call, strike price B
  • Buy a call, strike price C
  • Generally, the stock will be at strike B

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

Options Playbook 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:

  • Strike B plus net credit received.
  • Strike B minus net credit received.

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.

Margin Requirement

Margin requirement is the short call spread requirement or short put spread requirement (whichever is greater).

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.

Implied Volatility

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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A FEW THINGS YOU SHOULD KNOW

No statement in this web site is to be construed as a recommendation to purchase or sell a security, or to provide investment advice. Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options . Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, 125 S. Franklin Street, Suite 1200, Chicago, IL 60606 ( investorservices@theocc.com ).