Long Iron Butterfly
Direction: Sideways
Strategy Description
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 =
- 1 OTM Long Put + 1 ATM Short Put + 1 ATM Short Call + 1 OTM Long Call OR
- 1 Bull Put Spread + 1 Bear Call Spread OR
- 1 Narrow Short Straddle (Short ATM puts and calls) + 1 Wide Long Strangle (Long OTM puts and calls).
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 Risk:
- Limited to the different in adjacent strikes less net premium collected.
Maximum Reward :
- Limited to the Net Premium Collected when the underlying stock trade is at the middle strike price at expiration date.
Breakeven :
- Upside Breakeven = Middle Strike add Net Premium Collected
- Downside Breakeven = Middle Strike less Net Premium Collected.
Net Position:
- This is typically a net credit trade as you are combining two credit spreads: Bull Put Spread and Bear Call Spread at the same time.
Advantages and Disadvantages
Advantages:
- The biggest advantages is the opportunity to collect double (or near double) premium from a stock that is contracting in volatility.
- Limited risk exposure when the underlying stock moved beyond the breakeven point on expiration date.
Disadvantages:
- The limited profit potential only come from the narrow range between the 2 wing strikes.
- Bid/Ask spread from the various option legs may adversely affect the profit potential of the strategy.
- Risk on both direction. Dramatic advance or decline of the underlying stock will greatly increase the value of the call or put side. This may only be partially offset by the other side of the trade.
Exiting the Trade
- Offset the position by buying back the options that you sold and selling the options that you have bought in the first place.
- As the underlying stock fluctuate up and down, advance option traders may choose to unravel the spread leg by leg. In this way, the trader will leave one leg of the spread exposed while he profit from the closure of the other legs.
- Remembering that Long Iron Butterfly is a combination of other strategies, you can also unravel the spread in two legs. In this way, advance traders can create bullish, bearish, sideway or volatility strategies based on the underlying stock’s movement.
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
Maximum Risk
= Limited to the different in adjacent strikes less net premium collected.
= ($5.00 - $3.40) * 100 = $160
Maximum Reward
= Net Premium Collected
= ($1.70 - $0.50 + $3.00 - $0.80) * 100 = $340
Upside Breakeven
= Middle Strike Price Add Net Premium Collected
= $75 + $3.40 = $78.40
Downside Breakeven
= 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.
Related Strategies
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Long Call Butterfly
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Short Straddle
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Short Iron Butterfly
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Next go to another sideway strategy, Long Iron Condor, to learn how profit can be make from a range bound stock.
Return from Long Iron Butterfly to Option Strategies
