Definition: The Iron Butterfly Option strategy, also called Ironfly, is a combination of four different kinds of option contracts, which together make one bull Call spread and bear Put spread.
Together these spreads make a range to earn some profit with limited loss. Ironfly belongs to the ‘wingspread’ options strategy group, which is defined as a limited risk strategy with potential to earn limited profit. The strategy is considered when the future outlook of a security is neutral, and there is low volatility in the market.
The user of the strategy combines four option contracts with three different strike prices of the same expiry date, wherein he buys/sells higher strike price Put/Call options along with lower strike price Call/Put options, both of which are out-of-the-money, and also buys/sells another set of at-the-money Call/Put options at the middle strike price.
Thus, an iron butterfly option strategy involves the following:
1)Buying and selling of Call/Put options (Bull Call spread & Bear Put spread combination)
2)All options have the same underlying asset with same expiry date/expiration
3)It involves combining four option contracts
4)It involves three different strike prices; higher, middle and lower, where the difference between the middle strike price and the lower strike price or the upper strike price is the same. Two contracts have the same strike price.
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. The strategy gives best result and maximum profit when it is near to expiry and at-the-money, which means the underlying price is equal to the mid-strike price out of all strike prices. In this strategy, a butterfly-like image is formed where the Call and Put options of the mid-strike price form the ‘body’ and Call and Put options at higher and lower strike prices form the ‘wings’.
Example: The Tata Motors stock is trading at Rs 378.10. Now a trader forms a long iron butterfly strategy by buying one lot of December expiry Put option at a lower strike price of Rs 360 and one lot of same expiry Call option at a higher strike price at Rs 400 at values of Rs 1.25 (360 Put) and Rs 1.10 (400 Call) and then sells one lot each in Call and Put options at same the strike price of Rs 380 for Rs 5.65 (380 Call) & Rs 7.50 (380 Put).
Now, the trader’s profit at the entry of the trade would be Rs 10.80 = (Rs 5.65+Rs 7.50-(Rs 1.25+Rs 1.10)),
If the strategy fails, the maximum loss will be (Rs 400-Rs 380-Rs 10.80) = Rs 9.20 plus commissions
If Tata Motors trades at the same level of Rs 380 on expiry date in December end, then the Call option at the higher strike price will expire worthless as out-of-the-money (Strike price is more than the trading price), while the Put option at the lower strike price will again expire worthless (strike price is less than trading price) and there are two sold at-the-money Call and Put options, which expired worthless. So on expiry, the payout of this strategy will be Rs 10.80 minus the trading costs, which will be the actual profit/loss.
But if the trader decides to exit the strategy before expiry, when Tata Motors is trading around Rs 375 in cash market, and the options are trading at Rs 1.5 (360 Put), Rs 0.9 (400 Call), Rs 7.05 (380 Call) and Rs 6.5 (380 Put), the payout will be:
Call Option (Rs 400) – (Rs 0.9- Rs 1.10) = (-)Rs 0.2 (Loss)
Put Option (Rs 360) – (Rs 1.5- Rs 1.25) = Rs 0.25 (Profit)
Call Option (Rs 380) – (Rs 5.65- Rs 7.05) = (-)Rs 1.40 (Loss)
Put Option (Rs 380) – (Rs 7.50- Rs 6.50) = Rs 1 (Profit)
Net Profit & Loss = (-) Rs 0.35 plus commission and exchange taxes so in all loss
There are various risks to this strategy, which include:
1)High implied volatility or prices are very volatile
2)If cash price moves outside the strike price range, that can affect the delta of the strategy
3)It has a long expiry time, as sentiments in the market can change
4)Out-of-the-money expiry in case of all Calls or Puts or delivery on the expiry date can work in reverse way for this strategy
5)Higher trading costs, commissions and taxes
Long Iron Butterfly: This means buying one Call option at a higher strike price and Put option at a lower strike price, and simultaneously selling Call and Put options at a strike price near to cash price or the middle strike price of the same expiry and underlying asset (index, commodity, currency, interest rates).
The maximum a trader may lose is the (Long Call option strike price – Short put option strike price – net premium received + taxes paid), when the cash price is beyond the range of high and low strike prices on expiry. It will generate the maximum profit when the cash price is equal to middle strike price on the expiry day. The breakeven points of this strategy are:
Upper Breakeven Point = Strike price short call option (Strike Price + Premium received)
Lower Breakeven Point = Strike Price short put option (Strike Price - Premium received)
Short Iron Butterfly: This means selling one Call option at a higher strike price and one Put option at a lower strike price and, simultaneously, buying Call and Put options at a strike price near to cash price of the same expiry and underlying asset (index, commodity, currency, interest rates). A trader may lose maximum of premium paid plus taxes, which will occur when the cash price trades at same level. It will earn maximum profit when the cash price is beyond the range of lower and higher strike prices on the expiry day (Profit = (Short Call or Long Put) Strike Price – (Short Put or Long Call) Strike Price - Premium Paid – Taxes).
The breakeven points of this strategy are:
Upper Breakeven Point = Higher strike price long call/put option (Strike Price - Premium paid)
Lower Breakeven Point = Lower strike price long call/put option (Strike Price + Premium paid)
Source YouTube Channel: Option Alpha
