Long Iron Butterfly is one of the sideway strategies employed in a low volatile stock. It usually involves buying one lower strike (In The Money) put, selling one middle strike (At The Money) put and one middle strike call plus buying one higher strike (Out of The Money) call options of the same expiration date.
Typically the distance between each strike prices are equal for this strategy. Unlike the regular butterfly spread, Long Iron Butterfly is created by using a combination of puts and calls options instead of all calls or all puts options.
Long Iron Butterfly =
Outlook: With this stock option trading strategy, your outlook is directional neutral.
You are expecting a drop in volatility or no movement from the underlying stock.
Risk and Reward
Maximum Reward :
Advantages and Disadvantages
Exiting the Trade
Long Iron Butterfly Example
Assumption: XYZ is trading at $76.80 a share on Mar 20X1. You are expecting share price of XYZ to fluctuate back and forth within a strong support and resistance. You would like to profit from the low volatility of this stock but with limited risk exposure.
In this case, you may consider to buy one Apr 20X1 $70 strike put at $0.50, sell one Apr 20X1 $75 strike put at $1.70, sell one Apr 20X1 $75 strike call at $3 and buy one Apr 20X1 $80 strike call at $0.70 to profit from the low volatility outlook of the stock. Note: commissions are NOT taken into account in the calculation.
Analysis of Long Iron Butterfly Example
= Limited to the different in adjacent strikes less net premium collected.
= ($5.00 - $3.40) * 100 = $160
= Net Premium Collected
= ($1.70 - $0.50 + $3.00 - $0.80) * 100 = $340
= Middle Strike Price Add Net Premium Collected
= $75 + $3.40 = $78.40
= Middle Strike Price Less Net Premium Collected
= $75 - $3.40 = $71.60
A Long Iron Butterfly is a strategy whereby you combine two income strategies Bull Put Spread and Bear Call Spread to profit from a trading range or volatility contraction, or to take advantage of time decay. It is a four –legged spread option strategy consisting of puts and calls options and is the opposite of Short Iron Butterfly, which is a volatility strategy.
Before you executed this strategy, you must first determine at which price you believe the underlying stock most probably will be trading at the expiration date. This will be strike price (middle) where you will sell the two middle strike puts and calls options. Next buy a lower strike put option and a higher strike call option with equal distance from the middle strike sold to limit the risk exposed.
Try to ensure that the stock is trading range bound and identify clear areas of strong support and resistance. The stock is also anticipated to consolidate (become less volatile) and trading sideway for the duration of your trade.
Time decay is generally helpful in this strategy when it is profitable and harmful when it is in a loss position.
When you enter the trade, the stock price will typically be in the profitable area of the risk profile.
Therefore it is preferably to use this option trading strategy with around 1 month left to expiration so as to give yourself less time to be wrong.
As to whether a long butterfly strategy should be executed using all calls, all put options or a combination of puts and calls options depend largely on the relative price of the option. The premium of both puts and calls option should be taken into consideration to achieve the optimum trade.
You should pick the strike price and time frame of the Long Iron Butterfly according to your risk/reward tolerance and forecast outlook of the underlying stock. Having the patient to wait, knowledge to apply and discipline to follow through the option trading strategies with appropriate risk-reward parameters is important to your long term success in option trading.
Long Call Butterfly
Short Iron Butterfly