Understanding
Stock Options Trading
and Technical Analysis Basics

Short Iron Butterfly Option Strategy

The Iron Butterfly option 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, or 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 Short Iron Butterfly strategy is used for volatile stocks, and is a debit position. It is created by opening 2 option spreads. A call spread is opened by buying the at-the-money (ATM) call option and selling the out-of-the-money (OTM) call option. A put spread is opened by buying the ATM put option and selling the OTM put option.

For the Short Iron Butterfly strategy, 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 having to buy 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 - Sell 1 OTM Put, Buy 1 ATM Put, Buy 1 ATM Call, Sell 1 OTM Call
Short Iron Butterfly - Sell 1 OTM Put, Buy 1 ATM Put, Buy 1 ATM Call, Sell 1 OTM Call

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.

Summary:

The Short Iron Butterfly strategy is a debit position that is high in volatility but neutral in direction. 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.

Long Iron Butterfly options are the reverse of the Short Iron Butterfly, and are used for non-volatile stocks.

Do note that the Iron Butterfly strategy involves buying and selling 4 individual options to open the position, and also requires a bit of buying and selling to close the position. This means you will be paying a lot of commissions. 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 you.