What is an Iron Butterfly?
An iron butterfly is an options trade that employs four distinct contracts in a strategy aimed at profiting from stocks or futures prices remaining within a defined range. It’s also designed to benefit from declining implied volatility. The essence of this trade lies in forecasting periods of price stability and diminishing option values, often witnessed during sideways movements or mild upward trends. This trade is also affectionately known as the “Iron Fly.”
Key Takeaways
- Iron Butterfly trades profit from price movements within a narrow range during times of lessening implied volatility.
- The strategy combines elements of both short-straddle trades and long call/put options for protection.
- Traders should remain cognizant of commission costs to ensure this technique’s efficacy in their accounts.
- Be aware of the possibility of acquiring stock after expiration with this trade.
How an Iron Butterfly Works
Options traders craft “wingspread” strategies, which include setups like the condor spread, the iron butterfly, and the modified butterfly spread. The Iron Butterfly uses four options: two call options and two put options, spread over three strike prices with the same expiration date. The objective is to benefit from low volatility and price stability.
Think of it as a mix of both a short straddle and a long strangle. The straddle is at the middle strike price, while the strangle uses two additional strikes above and below this central price.
Setting Up the Trade
To achieve maximum profit, the underlying asset needs to close at the middle strike price when options expire. Here’s how a trader sets up this trade:
- Identify a target price where you believe the underlying asset will stabilize on a specific future date.
- Use options expiring around that forecast date.
- Buy a call option with a strike price higher than the target price—it will protect against a significant upward move and cap potential loss if the market doesn’t move as predicted.
- Sell both a call and a put option at the strike price nearest to the target price.
- Buy a put option with a strike price lower than the target price for protection against significant downward movements.
For instance, if a trader expects the asset to stabilize at $50 in two weeks, they should sell call and put options with a $50 strike price and buy call options $5 above and put options $5 below the $50 target. This increases the chance of landing within a profitable range by expiration.
Deconstructing the Iron Butterfly
The strategy is a credit spread, meaning you sell option premiums upfront. The goal is for option values to significantly decrease or drop to zero by expiration, allowing you to retain as much of the initial credit as possible.
The strategy inherently limits risk due to the protective options at higher and lower strike prices. Always account for commission costs when evaluating this trade—using four options can reflect noticeably in your earnings.
Iron Butterfly Trade Example
Consider a trade setup for IBM as an example:
In this scenario, the trader expects IBM’s price to rise slightly over two weeks due to positive earnings reports. Valuing the options at contract initiation leads to a $550 initial net credit. The trader profits if IBM stays between $154.50 and $165.50.
If IBM’s price is below $160 on expiration day, the trader can let the trade expire and be obligated to buy IBM shares at $160 per share. Subtracting the $5.50 credit per share from the buy price, they effectively paid only $154.50 per share, securing a $2.50 net profit per share.
Conclusion
Although some trading benefits of the Iron Butterfly can be simulated by simpler strategies—like selling a naked put—this practice offers unique protection against significant downward movements and benefits during periods of low volatility, distinguishing it from alternative setups like put calendar spreads.
Related Terms: Options, Volatility, Credit Spread, Condor Spread, Straddle.
