Short Iron Butterfly
Direction: Volatility in Either Direction

Strategy Description

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 =

• 1 OTM Short Put + 1 ATM Long Put + 1 ATM Long Call + 1 OTM Short Call
OR

• 1 Bear Put Spread + 1 Bull Call Spread
OR

• 1 Narrow Long Straddle (Long ATM puts and calls) + 1 Wide Short Strangle (Short OTM puts and calls).

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.

Click here to ask a question or discuss in more detail with fellow traders on the topics relating to Short Iron Butterfly strategy

Risk and Reward

Maximum Risk:

• Limited to the amount of Net Premium Paid for the various options entered. (May loss 100% of amount invested in this option trading strategy).

Maximum Reward :

• Limited to the different in adjacent strikes less net premium paid when the stock is at the middle strike price (at expiration).

Breakeven :

• Upside Breakeven = Middle Strike plus Net Premium Paid
• Downside Breakeven = Middle Strike less Net Premium Paid.

Net Position:

• This is typically a net debit trade as you are combining two debit spread: Bear Put Spread and Bull Call Spread at the same time.

Advantages and Disadvantages

Advantages:

• Make profit from extremely volatile stocks, without having to determine the direction.
• Limited risk exposure when the underlying stock is at the middle strike price on expiration date.

Disadvantages:

• Usually offer smaller return compare to straddle or strangle strategies with only slightly lower risk exposure.
• Significant movement of the stock and options prices is required for this strategy to be profitable.
• Bid/Ask spread from the various option legs may adversely affect the profit potential of the strategy.

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 Short 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.

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

Maximum Risk
= Limited to the amount of Net Premium Paid
= ($2.60 - $0.70 + $2.50 - $0.60) * 100 = $380
Maximum Reward
= Limited to the different in adjacent strikes less net premium paid
= ($5.00 - $3.80) * 100 = $120
Upside Breakeven
= Middle Strike Price plus Net Premium Paid
= $55 + $3.80 = $58.80
Downside Breakeven
= 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.


Related Strategies

Short Call Butterfly Volatility Strategy Limited Risk Limited Profit Credit Trade Same risk profile as Short Iron Butterfly Bear Call Spread + Bull Call Spread	Long Straddle Volatility Strategy Limited Risk Unlimited Profit Debit Trade Unlimited profit potential but higher cost compare to Short Call Butterfly Long Call + Long Put	Long Iron Butterfly Sideway Strategy Limited Risk Limited Profit Credit Trade Opposite risk profile of Short Iron Butterfly Bull Put Spread + Bear Call Spread

---

Next go to another volatility strategy, Short Iron Condor, to learn how profit can be make from a volatile stock.

Return from Short Iron Butterfly to Option Strategies