0 Iron Butterfly



 
The iron butterfly spread is a limited risk, limited profit trading strategy that is structured for a larger probability of earning a smaller limited profit when the underlying stock is perceived to have a low volatility.

Iron Butterfly Construction
Buy 1 OTM Put
Sell 1 ATM Put
Sell 1 ATM Call
Buy 1 OTM Call

To setup an iron butterfly, the options trader buys a lower strike out-of-the-money put, sells a middle strike at-the-money put, sells a middle strike at-the-money call and buys another higher strike out-of-the-money call. This results in a net credit to put on the trade. 

Limited Profit

Maximum profit for the iron butterfly strategy is attained when the underlying stock price at expiration is equal to the strike price at which the call and put options are sold. At this price, all the options expire worthless and the options trader gets to keep the entire net credit received when entering the trade as profit. 
The formula for calculating maximum profit is given below:
  • Max Profit = Net Premium Received - Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Short Call/Put
Graph showing the expected profit or loss for the iron butterfly option strategy in relation to the market price of the underlying security on option expiration date.
Iron Butterfly Payoff Diagram

Limited Risk

Maximum loss for the iron butterfly strategy is also limited and occurs when the stock price falls at or below the lower strike of the put purchased or rise above or equal to the higher strike of the call purchased. In either situation, maximum loss is equal to the difference in strike between the calls (or puts) minus the net credit received when entering the trade.
The formula for calculating maximum loss is given below:
  • Max Loss = Strike Price of Long Call - Strike Price of Short Call - Net Premium Received + Commissions Paid
  • Max Loss Occurs When Price of Underlying >= Strike Price of Long Call OR Price of Underlying <= Strike Price of Long Put

Breakeven Point(s)

There are 2 break-even points for the iron butterfly position. The breakeven points can be calculated using the following formulae.
  • Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
  • Lower Breakeven Point = Strike Price of Short Put - Net Premium Received

Example

Suppose XYZ stock is trading at Rs40 in June. An options trader executes an iron butterfly by buying a JUL 30 put for Rs50, writing a JUL 40 put for Rs300, writing another JUL 40 call for Rs300 and buying another JUL 50 call for Rs50. The net credit received when entering the trade is Rs500, which is also his maximum possible profit.
On expiration in July, XYZ stock is still trading at Rs40. All the 4 options expire worthless and the options trader gets to keep the entire credit received as profit. This is also his maximum possible profit.
If XYZ stock is instead trading at Rs30 on expiration, all the options except the JUL 40 put sold expire worthless. The JUL 40 put will have an intrinsic value of Rs1000. This option has to be bought back to exit the trade. Thus, subtracting his initial Rs500 credit received, the options trader suffers his maximum possible loss of Rs500. This maximum loss situation also occurs if the stock price had gone up to Rs50 or beyond instead.
To further see why Rs500 is the maximum possible loss, let’s examine what happens when the stock price falls below Rs30 to Rs25 on expiration. At this price, only the JUL 30 put and the JUL 40 put options expire in-the-money. The long JUL 30 put has an intrinsic value of Rs500 while the short JUL 40 put is worth Rs1500. Selling the long put for Rs500, and factoring in the intial credit of Rs500 received, he still need to fork out another Rs500 to buy back the short put worth Rs1500. Thus his maximum loss is still Rs500.



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