Short Iron Butterfly is one of the volatility strategies employed in a highly volatile stock. It usually involves selling one lower strike (Out of The Money) put, buying one middle strike (At The Money) put and one middle strike (At The Money) calls and selling 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, Short Iron Butterfly is created by using a combination of puts and calls options instead of all calls or all puts options.
Short Iron Butterfly =
Outlook: With this stock option trading strategy, your outlook is directional neutral.
You are expecting an increase in volatility of the underlying stock moving in either direction.
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Risk and Reward
Maximum Reward :
Advantages and Disadvantages
Exiting the Trade
Short Iron Butterfly Example
Assumption: XYZ is trading at $55.20 a share on Mar 20X1. The verdict of a legal law suit against the company is expected to be made soon. You are expecting share price of XYZ to soar up or plummet down once the verdict is out. You would like to profit from the volatility of this stock with limited risk exposure.
In this case, you may consider to sell one Jun 20X1 $50 strike put at $0.80, buy one Jun 20X1 $55 strike Put at $2.60, buy one Jun 20X1 $55 strike call at $2.50 and sell one Jun 20X1 $60 strike call at $0.60 to profit from the volatile outlook of the stock. Note: commissions are NOT taken into account in the calculation.
Analysis of Short Iron Butterfly Example
= Limited to the amount of Net Premium Paid
= ($2.60 - $0.70 + $2.50 - $0.60) * 100 = $380
= Limited to the different in adjacent strikes less net premium paid
= ($5.00 - $3.80) * 100 = $120
= Middle Strike Price plus Net Premium Paid
= $55 + $3.80 = $58.80
= Middle Strike Price less Net Premium Paid
= $55 - $3.80 = $51.20
A Short Iron Butterfly is a strategy whereby you combine 2 debit vertical spread strategies: Bear Put Spread and Bull Call Spread to profit in the event of a big move by the underlying stock. It is a four –legged spread option strategy consisting of puts and calls options and is the opposite of Long Iron Butterfly, which is a sideway strategy
Before you executed a Short Iron Butterfly strategy, you must first determine at which price the underlying stock will most probably NOT be trading at the expiration date. This will be strike price (middle) where you will purchase the two puts and calls options. Next sell a lower strike put option and a higher strike call option with equal distance from the middle strike purchased.
A Short Iron Butterfly is typically a bet on the volatility expansion. Verdict of law suit, product announcement, earning or economic reports do have a tendency to move the stock price sharply up or down. The maximum profit will be earned, at the expiration date, when the underlying stock moves beyond one of the breakeven points in either direction. The maximum loss will occur when the underlying stock close at the middle strike price at expiration day.
This is a net debit trade as you are paying the premium for both the puts and calls spreads.
Remembering that the last month of an option’s life has the greatest amount of time value erosion occurring.
Therefore it is preferably to use this option trading strategy with at least 3 months left to expiration so as to give yourself more time to be right.
As to whether a short 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 Short 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.
Short Call Butterfly
Long Iron Butterfly
Next go to another volatility strategy, Short Iron Condor, to learn how profit can be make from a volatile stock.
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