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What is an Iron Butterfly Strategy?

What is an Iron Butterfly Strategy?

An iron butterfly is a sophisticated options strategy that combines four separate options contracts. The Iron Butterfly Strategy is also known as the Iron Fly Strategy. An iron butterfly is essentially a combination of two spread strategies: a bull put spread and a bear call spread.

An iron butterfly approach is a limited risk, limited reward strategy that is supposed to have a high likelihood of achieving a modest restricted return when the underlying asset is thought to be volatile.

Iron butterflies are commonly used by investors and traders who anticipate little or no volatility in the underlying. Iron butterflies are made up of four option contracts, two with the same strike price and two with separate strike values.

Understanding an Iron Butterfly Strategy

The 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. 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 Rs. 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 Rs. 180 at a premium of Rs. 3.

Buy a Call Option (Option B) with a strike price of Rs. 220 at a premium of Rs. 2.80.

Sell a Call Option (Option C) with a strike price of Rs. 200 at a premium of Rs. 6.

Sell a Put Option (Option D) with a strike price of Rs. 200 at a premium of Rs. 5.50.

The trader's initial profit is the difference between the premium received and paid, which is Rs. 1.70 (Rs. 6 + Rs. 5.50 - Rs. 3 - Rs. 2.80).

Now, let's consider different scenarios:

If ABC closes at Rs. 200 in October:

Options A and B expire worthless.

Both Options C and D expire worthless too.

The net premium gain remains Rs. 1.70.

Suppose ABC closes at Rs. 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 Rs. 10 (the difference between the spot price and the strike price).

The net gain will be reduced to Rs. 1.70 - Rs. 10 = Rs. -8.30 (a loss).

In summary, the maximum loss is limited to the difference between the higher/lower strike price and the strike price of the options involved, minus the net premium received. Meanwhile, the maximum gain is capped at the net premium earned.

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Table of Content

  1. Understanding an Iron Butterfly Strategy
  2. How to use the Iron Butterfly Strategy?
  3. Benefits Of the Iron Butterfly Strategy

How to use the Iron Butterfly Strategy?

  • To use the Iron Butterfly strategy, you need to consider a few key points.
  • The goal of the Iron Butterfly strategy is to earn a maximum profit when the option closes "at the money," which means the price of the underlying asset is the same as the middle strike price.
  • The closer the underlying asset's price is to the middle strike price, the higher your profit will be.
  • So, the Iron Butterfly strategy works within a specific range where you can earn an overall profit.
  • If the underlying asset's price goes beyond that range, it results in a loss.
  • In simpler terms, the Iron Butterfly strategy has a specific range within which you can make a profit.
  • It works best when the market is not too volatile.
  • If the price of the underlying asset moves too much, the strategy may not be effective.

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 moves outside the defined range, the trader may choose to close out some of the position and hold the remaining bull put or bear call spread. The trader also has the option of rolling up or rolling down the position to hedge his 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.