The iron butterfly is an option strategy that involves two calls and two puts with the same expiration date but three different strike prices.
The iron butterfly is an option strategy that can provide a small profit with limited risk. This article will explain the basics of this conservative, yet effective strategy.
The goal of the iron butterfly is to profit from low volatility in the underlying asset. Its maximum profit will occur when the underlying security closes at the middle strike price at expiration.
In order to construct an iron butterfly, an investor must do the following:
- Buy one “out-of-the-money” put option with a strike price below the current price of the underlying security. This option protects against any significant downside move in the underlying security’s price.
- Sell one “at-the-money” put option with a strike price equal to or near the current price of the underlying security.
- Sell one “at-the-money” call option with a strike price equal to or near the current price of the underlying security.
- Buy one “out-of-the-money” call option with a strike price above the current price of the underlying security. This option protects against a significant move upward in the underlying security’s price.
The “out-of-the-money” options are the wings of the strategy. Both of these options have lower premiums than the “at-the-money” options. Therefore, selling the two “at-the-money” options pays for the two “out-of-the-money” options.
Let’s look an example of this strategy in action.
Assume stock ABC is trading at $50. An investor executes an iron butterfly by buying a put option with a strike price of $45, selling a put option with a strike price of $50, selling a call option with a strike price of $50, and buying a call option with a strike price of $55. All of the options expire in a month.
The investor buys the “out-of-the-money” put and call option for $100 each. The investor gets a premium of $300 each for selling the “at-the-money” put and call option. From these transactions, the investor enters the trade with a profit of $400 ((2*300) – (2*100) = 400). This is also his maximum potential profit.
If ABC expires at $50 in one month, then all four options will expire worthless. The investor will walk away with the $400 profit.
If ABC expires at $45 in one month, all of the options expire worthless, except for the put option sold with a strike price of $50. That option would be exercised, thus obligating the investor buy the shares of stock at $50 rather than $45. This is a loss of $500 for the investor. However, he did receive a profit of $400 entering the trade. So his total loss would only be $100 (500 – 400 = 100). This is his maximum potential loss.
If ABC expires at $55 in one month, then a similar scenario would occur. All of the options would expire worthless, except for the call option sold with a strike price of $50. That option would be exercised, thus obligating the investor to sell the shares of stock at $50 rather than $55. This causes a loss of $500 for the investor. After accounting for the $400 premium, the total loss comes out to be $100.
If ABC expires at $40 in one month, then both call options would expire worthless, but both put options would be exercised. The put option sold with a strike price of $50 would cost the investor $1000. The put option bought with a strike price of $45 would generate a profit of $500 for the investor. From these two transactions, the investor would be at a loss of $500. After factoring in the $400 premium received, the total loss becomes $100. This proves that his maximum loss is still $100.
These are a few scenarios of what could happen when using the iron butterfly strategy. The best-case result happens when the price of the underlying security closes at the middle strike price at expiration.
When an investor believes that a stock is going to remain relatively neutral, then the iron butterfly is a low-risk strategy that can be used to generate a limited profit.
