Butterfly Option Strategy

What is the Iron Butterfly Strategy?

The Iron Butterfly Strategy is an options trading strategy which has been designed to profit from minimal price movement in the underlying asset. It is the combination of a bull put spread and a bear call spread to create a limited risk and limited profit setup. This options strategy involves four options contracts with the same expiration date but different strike prices.

To put it simply, think of it like a spinning wheel at a carnival where you bet that the wheel will stop on a number close to the middle. You place small bets on numbers around it, just in case. If the wheel lands exactly on your chosen number, you win big! If it lands a bit off, you still get something. But if it lands far away, you lose your bets.

Similarly, with the Iron Butterfly, you make the most profit when the stock price stays near a specific strike price at expiration. If the price moves too far from that point, your potential losses increase, but they are limited. Traders use this strategy when they expect the market to stay neutral without much volatility. It’s a strategy to earn a defined profit while keeping the risks manageable, making it a practical choice when market conditions are relatively stable.
 

How to Build the Iron Butterfly Strategy?

The Iron Butterfly Options Strategy is built using four legs or options trades involving calls and puts on the same underlying asset, all with the same expiration date.

This particular combination of trades, as elaborated below, forms a shape that resembles a butterfly on the payoff diagram, with the middle strikes acting as the body and the outer strikes forming the wings.

Here’s How to Construct It:

• Buy an Out-of-the-Money (OTM) Put Option with Strike Price A (lower than the current market price).
• Sell an At-the-Money (ATM) Put Option with Strike Price B (approximately equal to the current market price).
• Sell an At-the-Money (ATM) Call Option with Strike Price B (same as the put option above).
• Buy an Out-of-the-Money (OTM) Call Option with Strike Price C (higher than the current market price).

Understanding the Setup:

• Strike Price B is the center or “body” of the butterfly and is usually close to the current market price of the underlying asset.
• Strike Prices A and C form the “wings” and are positioned equidistant from Strike Price B.
• The OTM put (Strike Price A) and the OTM call (Strike Price C) define the range, while the ATM put and call (Strike Price B) create the body of the butterfly.

The structure of the Iron Butterfly visually represents a butterfly with two wings spread out on either side of a central body, signifying the narrow profit range at the middle strike price and the wider loss range beyond the wings.

This setup ensures limited risk and limited reward, making it an ideal choice for traders expecting the underlying asset to remain stable around the middle strike price.
 

How does the Iron Butterfly Strategy Work?

In the Iron Butterfly Strategy, the trader collects a net premium by selling at-the-money call and put options where both options have the same strike price. At the same time, the trader buys out-of-the-money call and put options which helps to limit potential losses.

The main goal is for the stock price to stay as close as possible to the middle strike price by expiration. If the stock price remains near this middle strike price, all options expire worthless. In this case, the trader keeps the net premium as profit.

However, if the stock price moves significantly away from the middle strike price, the long call or long put options come into play as they help reduce the potential losses.
 

Example of a Short Iron Butterfly Strategy

Let’s break down the Short Iron Butterfly Strategy using an example. Suppose the shares of ABC Corporation are currently trading at ₹200. You expect the stock to stay within a certain range over the next month, so you decide to implement the Short Iron Butterfly Strategy.

Calculating the Net Premium:

• Assuming each option has a lot size of 1,000 shares, your initial gain would be:
• Net Premium Collected =(25×1,000+25×1,000)−(15×1,000+15×1,000)
• Net Premium=(25,000+25,000)−(15,000+15,000)=50,000−30,000=20,000
• Your initial net premium collected is ₹20,000.

Profit Scenario:
If the share price remains stable and closes at the middle strike price of ₹200 at expiration, all four options will expire worthless. In this ideal scenario, the buyers won’t exercise their rights, allowing you to retain your initial profit of ₹20,000.

Loss Scenario:
A loss may occur if the share price moves below ₹180 or above ₹220 at expiration. In such cases, the call or put buyer might exercise their rights, resulting in a loss that exceeds the premium collected.
 

Example of a Long Iron Butterfly Strategy

Let’s break down the Long Iron Butterfly Strategy using an example. Suppose the shares of DEF Corporation are currently trading at ₹300. You expect significant price movement in the next month, either up or down, and decide to implement the Long Iron Butterfly Strategy.

Calculating the Net Premium:

Assuming each option has a lot size of 1,000 shares, your initial net premium would be:

• Net Premium Paid = (25 × 1,000 + 25 × 1,000) − (10 × 1,000 + 10 × 1,000)
• Net Premium = (25,000 + 25,000) − (10,000 + 10,000)
• Net Premium Paid = 50,000 − 20,000 = 30,000

Your initial net premium paid is ₹30,000.

Profit Scenario:

If the share price moves significantly away from the middle strike price of ₹300, either above ₹320 or below ₹280, then you stand to make a profit, depending on how big the move is. 

Loss Scenario:

A loss will occur if the share price stays close to ₹300 at expiration.
 

Advantages and Disadvantages of the Iron Butterfly Strategy

When Should Traders Consider Using an Iron Butterfly?

The Iron Butterfly Strategy may be considered when traders expect the underlying asset to remain stable within a narrow range over the duration of the strategy. This approach is generally suitable for low volatility environments, such as during periods of market consolidation or when major economic events are not expected to cause drastic price movements.

The strategy is effective when option premiums are high, and implied volatility is set to drop. The Iron Butterfly suits traders who prefer defined risk-reward setups. Checking the option chain helps assess potential profitability.