What does an Iron Butterfly do?
An iron butterfly is a type of options trade that uses four different contracts to make money when the prices of stocks or futures move within a specific range. The trade is also set up to make money when expected volatility decreases. To make this trade work as part of a successful trading plan, you need to be able to guess when option prices will usually go down in value. Most of the time, this happens when the price moves sideways or slightly up. The job is also sometimes called “Iron Fly.”
How a Butterfly Iron Works
“Wingspread” trade methods comprise several bull and bear trades with the exact expiration dates. These trading techniques include the corner spread, the iron butterfly, and the modified butterfly spread. You need four options to make an Iron Butterfly deal. There are two call options and two put options. There are three strike prices for these calls and puts, but they all expire on the same day. The goal is to make money when the price stays mostly the same, and the implied and past volatility of the options goes down.
You can also think of it as a trade that uses a short straddle and an extended choke. The straddle is placed in the middle of the three strike prices, and the strangle is placed on two more strikes above and below the middle strike price.
Getting the deal done
The trade makes the most money when the underlying asset closes on the middle strike price at the end of the expiry period. The steps below show how a seller will make an Iron Butterfly trade.
First, the trader picks a price they think the base asset will be at on a particular day. This price is the goal.
The trader will use options that end on or near the day they think the price will reach their goal.
The trader buys one call option with a strike price much higher than the price they want to make. At the expiration time, this call option will likely be worth less than its face value. It will protect against a significant rise in the base asset and limit the amount of money lost if the trade doesn’t go as planned.
The trader sells a call option and a put option with the strike price closest to the goal price. This strike price will be higher than the put option bought in the next step and lower than the call option bought in the last step.
A trader buys one put option with a strike price much less than the price they want to make. At the expiration time, this put option will likely be worth less than its face value. It will protect against a significant drop in the base asset and limit the amount of money lost if the trade doesn’t go as planned.
When you sell options in steps two and three, the strike prices should be far apart to allow for a range of possible changes in the underlying. This way, the trader can predict a range of price changes that will work instead of a narrow range close to the goal price.
A trader might think that the underlying could reach $50 in the next two weeks, with a range of five dollars higher or lower from that price. In this case, the trader would sell a call option and a put option with a strike price of $50 and buy a call option at least five dollars higher and a put option at least five dollars lower than the $50 target price. Theoretically, this makes it more likely that the price will land in and stay in a profitable band on or near the day the options expire.
Taking apart the Iron Butterfly
The approach is meant to have limited upside profit potential. The trader sells option premiums and gets credit for the value of the options at the start of the trade. This is called a credit-spread plan. To make money, the trader hopes that the options’ value will decrease until they have almost no value. Because of this, traders want to keep as much of the credit as possible.
The strategy limits risk because it has high and low strike options, also known as “wings.” These options protect against big moves in either way. Since this strategy has four choices, commission costs are always a thing to consider. Traders will want to ensure that the commissions their broker charges don’t take away much of the highest profit that could be made.
As the expiry date gets closer, the Iron Butterfly trade makes money if the price stays in a range near the center strike price. Traders sell both a call option and a put option at the same price, called the center strike. The trade loses value as the price moves away from the middle strike, either higher or lower. It loses the most value when the price moves below the lower or above the higher strike price.
Example of an Iron Butterfly Trade
The chart below shows a trade plan for IBM that uses an Iron Butterfly.
The trader, in this case, thinks that the price of IBM shares will go up a little over the next two weeks. Two weeks ago, the company put out its earnings report, which was positive. The trader thinks that the options’ expected volatility will generally decrease over the next two weeks and that the share price will rise. So, to make this trade happen, the trader gets an initial net credit of $550, which is $5.50 per share. The broker will make money if the price of IBM shares stays between 154.50 and 165.50.
Traders can close a deal early and make money if the price stays in that range until the day it expires or just before. This is done by the investor selling the call and putting options that were bought before and buying back the call and putting options that were sold at the start of the trade. This can usually be done with just one order at most providers.
If the price stays below 160 on the expiration day, the trader will have another chance to make a profit. The trader can then let the trade end and pay $160 per share for the sold IBM shares (100 shares per put contract).
For example, let’s say that IBM’s share price closes that day at $158. If the trader lets the options end, they must buy the shares for $160. All of the trader’s other option contracts end worthless, so there’s nothing they need to do. It might look like the trader just bought stock for two dollars more than it was worth, but keep in mind that the trader got a refund of $5.50 per share. In other words, the net deal can be seen in different ways. The trader could buy IBM shares and make $2.50 on each one ($5.50 minus $2.00).
It’s possible to get most of the benefits of the Iron Butterfly trade in trades with fewer option legs, which means lower fees. You can sell a “naked put” or buy a “put-calendar spread.” On the other hand, the Iron Butterfly protects you cheaply from sharp drops in the price of the stock that the naked put does not. Implied volatility going down also helps the trade, which the put time spread can’t do.
Conclusion
- People use Iron Butterfly trades to make money when prices move in a narrow band when implied volatility is going down.
- The trade is set up like a short-straddle trade, but a long call option and a long put option are bought for extra security.
- To ensure they can use this strategy well in their account, traders need to keep fees in mind.
- Traders should know that their trade could mean buying the company after expiration.
