Understanding
Stock Options Trading
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Iron Butterfly Strategy

The Iron Butterfly strategy is an advanced option strategy that combines two vertical spreads (one call spread and one put spread) to create a position that is useful for when you expect low volatility, and for when you expect high volatility but are unsure of the direction. As the name implies, the Iron Butterfly is similar to the Butterfly and Iron Condor strategies. It has the same profit and risk profile as the Butterfly, but uses a similar combination of option spreads as the Iron Condor.

The Long Iron Butterfly is the most commonly used version of the Iron Butterfly, and is suitable for stocks that won't move much (low volatility). Like the Butterfly and Iron Condor, this strategy also suffers from the problem of prohibitive costs (depending on your broker commissions). The two option spreads consist of a total of 4 individual options, and the resulting commissions to open and close the position may make this strategy not as profitable as it looks on paper.

The position is created by opening two sets of option spreads. The first spread is a call spread which consists of selling an At-the-Money (ATM) call option and buying an Out-of-the-Money (OTM) call option. The second spread is a put spread which consists of selling an ATM put option and buying an OTM put option.

Long iron butterfly individual components

Long iron butterfly composite

The profit you earn from this strategy is a bit complicated. This is a credit spread, where opening the position will net you your maximum profit from selling the ATM options. At option expiry time, if the underlying stock price is just above the ATM strike price, the ATM call option that was sold earlier will need to be bought back to close the position. The higher the stock price goes, the more you will need to pay to close this position. However, the loss is capped once the stock price hits the OTM call strike price. Beyond this point, any losses incurred from buying back the ATM call will be offset by the income generated from selling the OTM call. Through all of this, both put options will expire worthless, and you keep the premium made on the put spread.

The reverse happens if the underlying stock price falls below the ATM strike price. In this case, the call spread will expire worthless and you get to keep the premium made there. However, you will need to close the put spread position. You will need to buy back the ATM put you sold earlier, and the cost will increase the further the stock price falls. But once the price falls below the OTM put strike price, any losses made from buying back the ATM put option will be offset by the income generated from selling the OTM put option.

This makes the long butterfly a neutral option strategy for low volatility, and your profit is maximized (from the initial premium made) if the stock price stays at the ATM strike price. The profit will drop the further the underlying stock price moves from the ATM strike price. This is also a low-risk strategy, since your losses are limited if the stock crashes or climbs unexpectedly.

Easy-speak A long iron butterfly is a credit position and involves opening a call spread (sell ATM call and buy OTM call) and a put spread (sell ATM put and buy OTM put). It is a neutral low-risk strategy for low volatility stocks. You reach maximum limited profit if the stock doesn't move. You will incur maximum limited losses if the stock climbs too high or falls too low.

A Short Iron Butterfly is the reverse of the long iron butterfly and is a debit position. It is created by reversing the 2 option spreads of the long iron butterfly. This time, the call spread is opened by buying the ATM call option and selling the OTM call option. The put spread is opened by buying the ATM put option and selling the OTM put option.

The short iron butterfly's profit profile is also the reverse. You start with a debit position, since the premiums earned from selling the OTM options will be less than the cost of buying the ATM options. Come expiry time, the further the underlying stock price rises from the ATM strike price, the more you will earn from selling the ATM call option. But once you hit the OTM call strike price, this profit will be capped due to buying back the OTM call option. The same thing happens in the other direction. The further the stock price falls, the more profit is earned from selling the ATM put option. This profit is also capped once the price falls below the OTM put strike price and you need to buy back the OTM put option.

Short iron butterfly individual components

Short iron butterfly composite

As can be seen, the short iron butterfly is a strategy that is high in volatility but neutral in direction (i.e. you expect the stock to move a lot, but aren't sure in which direction). As a side note, this might not be the best strategy for you if you are indeed expecting high volatility and are uncertain in stock price direction. Both the Straddle and the Strangle strategies are also appropriate for high volatility and neutral direction. However, they have the extra benefits of being able to earn unlimited profit and requiring less commissions to open and close them.

Easy-speak A short iron butterfly is a debit position that is high in volatility but neutral in position. It is created by buying an ATM call and selling an OTM call, together with buying an ATM put and selling an OTM put. You incur maximum losses if the stock price doesn't move, and gain maximum limited profit when the stock price moves a lot.

As has been mentioned before, both the long and short Iron Butterfly strategies involving buying and selling 4 individual options to open the positions, and also require a bit of buying and selling to close the positions. This means you will be paying a lot of commissions (for most option brokers). You will need to consider these extra commissions (which differ from broker to broker) when trying to determine if the iron butterfly is suitable for your trading situation.


Other Topics in this Guide

Bullish Strategies Bearish Strategies Neutral Non-Volatile Strategies Neutral Volatile Strategies

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