What is an Iron Butterfly Strategy in Derivatives

What is an Iron Butterfly Strategy?

19 Sept 2024
By: BlinkX Research Team

The Iron Butterfly Strategy, also referred to as the Iron Fly Strategy, involves combining two different types of option contracts to create a bull call spread and bear put spread. The strategy aims to make a small, consistent profit with only a small risk and a small reward. When the underlying asset's price stays stable, it is most effective. In this blog, we will cover everything from the iron butterfly options strategy to its use, meaning, benefits, and many more.

Understanding an Iron Butterfly Strategy

Iron Butterfly Strategy or Iron Fly Strategy involves the combination of multiple calls and puts to create a market-neutral strategy. A short call spread and a short put spread are run simultaneously in the Iron Butterfly Strategy and at a middle strike price, the spread converges. In general, iron butterfly options strategies include the following:

A combination of four options contracts with the same expiration date.
There are three types of strike prices - upper, middle, and lower.
Bear call spreads and bull put spreads converge at the middle strike price.

Iron Butterfly Strategy Example

Imagine a trader is considering ABC, which is trading at ₹200 in September. They decide to use the Iron Butterfly strategy for October by executing the following trades:

Buy a Put Option (Option A) with a strike price of ₹180 at a premium of ₹3.
Buy a Call Option (Option B) with a strike price of ₹220 at a premium of ₹2.80.
Sell a Call Option (Option C) with a strike price of ₹200 at a premium of ₹6.
Sell a Put Option (Option D) with a strike price of ₹200 at a premium of ₹5.50.

The trader’s initial net premium received is ₹5.70, calculated as follows:

Total premiums received: ₹6 (Option C) + ₹5.50 (Option D) = ₹11.50
Total premiums paid: ₹3 (Option A) + ₹2.80 (Option B) = ₹5.80
Net premium received: ₹11.50 - ₹5.80 = ₹5.70

Now, let's consider different scenarios:

If ABC closes at ₹200 in October:

Options A and B expire worthless.
Both Options C and D expire worthless too.
The net premium gain remains ₹1.70.

Suppose ABC closes at ₹210 in October:

Options A, B, and D expire out of the money, becoming worthless.
If Option C is squared off, the trader will face a loss of ₹10 (the difference between the spot price and the strike price).
The net gain will be reduced to ₹1.70 - ₹10 = ₹-8.30 (a loss).

Summary: The maximum gain is ₹5.70, which occurs when the underlying asset closes exactly at the middle strike price of ₹200.

The maximum loss is ₹34.30, which is the difference between the strike prices of ₹20 (₹220 - ₹180) minus the net premium received of ₹5.70.

Table of Content

Understanding an Iron Butterfly Strategy
How to Use the Iron Butterfly Strategy?
Benefits of the Iron Butterfly Strategy

How to Use the Iron Butterfly Strategy?

To use the Iron fly strategy, you need to consider a few key points:

Define the Middle Strike Price: The iron fly strategy works best when the underlying asset’s price is close to the middle strike price, maximizing profits.
Set up the strategy: Select the first and second leg with the first upper strike price and second lower strike price to get a short call spread and short put spread with the equal middle strike price.
Monitor the range: Namely, the Iron Butterfly strategy is beneficial if the price stays in a certain range during the contract’s lifetime. The strategy may result in a loss if the price of the actual asset drops within the given range.
Adjust Positions if Necessary: Alternatively, changes to the market, shifts in the price of the underlying asset and more may make it necessary to make changes.

Benefits of the Iron Butterfly Strategy

The following are the benefits of the Iron Butterfly strategy.

Profit and loss are predefined: Through this strategy, an investor can make an informed decision based on an analysis of risk and reward.
The minimum amount of capital needed: It is relatively easy to execute an iron butterfly strategy with a small amount of capital. Compared to other directional spreads, it provides steady income.
Opt-Out if the range exceeds: If the price of the underlying asset moves outside the defined range, the trader may choose to close out some of the positions. They can then hold the remaining bull put or bear call spread, or adjust their strategy by rolling up or rolling down the position to mitigate potential losses.

Conclusion

A unique approach to options trading, the Iron Butterfly Strategy enables traders to trade within a range and potentially make money in low-volatility markets. Combining bear call spreads and bull put spreads, this strategy finds the optimal middle strike price. However, a trader must consider market volatility when implementing this strategy and ensure the price of the underlying asset remains within the defined range. Moreover, with the BlinkX trading app, traders can explore Iron Butterfly Strategies and other options trading strategies easily.

FAQs on Iron Butterfly Strategy

Iron butterfly options are a good options strategy if you have a neutral outlook for the stock and believe it won't move much before expiration.

There is a higher chance of earning profit in Iron Butterfly because it combines Calls and Puts or Bear Put and Bull Call spreads. By combining bull spreads and bear spreads, it becomes different from a classic Butterfly option strategy, which combines bull and bear spreads.

A maximum loss is the difference between the strike prices of the calls or puts subtracted by the premium you paid when you opened the trade.

Whenever the asset closes exactly on the middle strike price at expiration, the trade makes the most money.

Iron Butterfly is a credit spread that combines four options for a limited risk/profit. Thus, low volatility is the best time to use the strategy.

Long Iron Butterfly and Short Iron Butterfly are the two varieties of iron butterfly options strategies. A short iron butterfly, as described above, entails purchasing a lower strike put, a higher strike call, and selling a middle strike call and put. Long iron butterfly, on the other hand, necessitates selling a lower strike put, a higher strike call, and purchasing a middle strike call and put. As a result, a short iron butterfly strategy is a net credit strategy, whereas a long iron butterfly approach is a net debit strategy.

The Iron Butterfly method may be defended by either settling a portion of the position or rolling it up or down depending on the underlying security's price movement.

The success rate of iron fly strategy is between 20% and 30%. The strategy shows full profit only 23% of the time. This indicates that a maximum of two weeks' profit could be given to the trader.

There is limited risk in iron fly strategy because of its defined spread. However, sudden market movements can lead to losses, especially outside the predefined profit range.

Open Free* Demat Account