What is an Iron Butterfly Option Strategy & How Does it Work? (2024)

FAQs

What is an Iron Butterfly Option Strategy & How Does it Work? ›

An iron butterfly is an options trade that uses four different contracts as part of a strategy to benefit from stocks or futures prices that move within a defined range. The trade is also constructed to benefit from a decline in implied volatility.

Iron Butterfly: You believe a stock will stay very close to a specific price. You sell options right at that price (at-the-money) and buy options further away (out-of-the-money) for protection. This gives you a higher potential profit but a narrower range for that profit.

Now we will look at a commonly traded strategy, referred to as a butterfly. Going long a butterfly, the trader buys a call of a low strike, sells two calls of a middle strike, and buys a call of a high strike. The three strikes are equidistant. The options have the same expiration and the same underlying product.

It may generate a stable income and reduce the risks as much as possible compared with directional spreads, using very little capital. What is the success rate of the iron butterfly strategy? There is a 20% to 30% probability of an iron butterfly achieving any profit. It makes an entire profit only 23% of the time.

This is accomplished by exiting the full position, exiting one spread, or buying back only the short options. Technically, for an iron butterfly to achieve maximum profit, the underlying stock price would need to close at-the-money of the short options.

The maximum potential loss on this trade is limited to the cost of creating the butterfly spread. Maximum profit potential = Strike price of the sold call—strike price of the low strike purchased call—net cost of constructing the butterfly spread. Maximum loss = Net cost of constructing the butterfly spread.

The difference in strike price between the calls or puts subtracted by the premium received when entering the trade is the maximum loss accepted. The formula for calculating maximum loss is given below: Max Loss = Strike Price of Long Call − Strike Price of Short Call − Premium.

The most successful options strategy for consistent income generation is the covered call strategy. An investor sells call options against shares of a stock already owned in their portfolio with covered calls. This allows them to collect premium income while holding the underlying investment.

In short, close the butterfly in two orders

Since butterfly spread is a long debit spread and a short credit spread pinned on the short strike, the best way to close out of it is by doing TWO separate balanced closing orders –an order for the debit spread and a closing order the credit spread.

A Bull Call Spread is made by purchasing one call option and concurrently selling another call option with a lower cost and a higher strike price, both of which have the same expiration date. Furthermore, this is considered the best option selling strategy.

What are the pros and cons of iron butterfly strategy? ›

Description: In Iron Butterfly, there is a higher probability of earning profit because the way it is constructed by combining Calls and Puts or bear Put and bull Call spread, it becomes different from a classic Butterfly option strategy, where the strategy involves a combination of either bull spreads or bear spreads.

For example, let's say ABC Co. rallied to $50 in August and the trader wants to use an iron butterfly to generate profits. The trader writes both a September 50 call and put, receiving a $4.00 premium for each contract, and also buys a September 60 call and September 40 put for $0.75 each.

The trade earns the maximum profit when the underlying asset closes exactly on the middle strike price on the close of expiration. A trader will construct an Iron Butterfly trade with the following steps.

The OTM butterfly strategy can offer a low-risk trade with an attractive reward-to-risk ratio and a high probability of profit if the stock does move higher when using calls.

Description: In Iron Butterfly, there is a higher probability of earning profit because the way it is constructed by combining Calls and Puts or bear Put and bull Call spread, it becomes different from a classic Butterfly option strategy, where the strategy involves a combination of either bull spreads or bear spreads.