The Iron Butterfly is an advanced options trading strategy designed to profit from low volatility in the market. It involves four different options contracts and is considered a neutral strategy, meaning traders expect the underlying asset to stay within a specific price range.
How the Iron Butterfly strategy works
- Selling a call and a put at the same middle strike price (this forms the “body” of the butterfly).
- Buying a call at a higher strike price and buying a put at a lower strike price (these form the “wings” of the butterfly).
The credit spread allows for traders to open positions with a net premium. The maximum profit occurs if the underlying asset closes exactly at the middle strike price at expiration, while losses are limited due to the protective wings.
Key Points
- Best for low-volatility markets where price movement is expected to stay within a narrow range.
- Limited risk and limited profit make it a conservative strategy.
- Requires careful management of commissions, as four contracts are involved.
- Breakeven points are determined by adding/subtracting the premium received from the middle strike price.
Iron Butterfly Example
If a trader believes a security will stay around $50 until expiration but wants to profit from low volatility, the trader may:
- Sell a $50 call and sell a $50 put (this forms the “body”).
- Buy a $60 call and buy a $40 put (these form the “wings”).
Premiums Received & Paid
- The trader receives $4.00 per contract for selling the $50 call and put.
- They pay $0.75 per contract for buying the $60 call and $40 put.
- The net result is an initial credit of $650 after subtracting the cost of the long positions from the premium received
Profit & Loss
- Maximum profit occurs if the security. closes exactly at $50 at expiration.
- Breakeven points are $43.50 and $56.50, calculated by adding/subtracting the premium received from the middle strike price.
- Maximum loss happens if the stock moves beyond the breakeven points, but losses are limited due to the protective wings.
Remember, the Iron Butterfly strategy is ideal for low-volatility markets where price movement is expected to stay within a narrow range.
