Iron Butterfly Options Strategy Explained (Simple Guide)
If you’re a seasoned options trader and you’d like to make a profit off of a stock that will stay within a price range in the near term, consider using an iron butterfly strategy.
You really need to know what you’re doing, though. An iron butterfly involves four trades.
It’s really best left to options veterans.
Some of those veterans make a nice return with it. In fact, there are traders who use iron butterfly regularly to create an income stream.
In this guide, I’ll explain the iron butterfly strategy so that you can determine if it’s right for you.
What Is an Iron Butterfly?
An iron butterfly is one of the more complicated options strategies. It involves both a bear call spread and a bull put spread.
There are three strike prices involved: a middle strike price, a lower strike price, and a higher strike price.
One call option and one put option are both sold at the middle strike price.
The other call option is purchased at the higher strike price. The other put option is purchased at the lower strike price.
As a result of the whole transaction, you’ll get a credit to your account. That’s because you’ll earn more from the sale of the options at the middle strike price than you’ll pay for the purchase of the other options.
The trade will stay profitable when the underlying security stays between the upper and lower strike prices at expiration. If it goes above the higher strike price or below the lower strike price, you’ll have to close out the whole trade for a loss.
When Would You Use an Iron Butterfly?
Use an iron butterfly when you think that a stock will stay within a specific price range in the near term.
Remember, you’ll lose money with an iron butterfly if the underlying stock goes higher than the highest strike price or lower than the lowest strike price at expiration.
If it stays anywhere in between those two strike prices, the trade will stay profitable (assuming you don’t get whacked by commissions).
Some traders prefer to use an iron butterfly on index options. That’s because index options tend to be less volatile than individual stocks.
That’s not always the case, though. Index ETFs can sink quite a bit when hedge fund managers and investors get nervous.
Read Also: How Does An Options Delta Work?
How Does an Iron Butterfly Work?
For starters, make sure that your trading platform supports multi-leg orders. That’s because an iron condor involves entering four trades at the same time.
If you try to enter those trades individually, you could miss the low points on the options you’re buying and the high points on the options you’re selling. In other words, you’ll spend more money than you have to.
With a multi-leg order, you can put a limit on the whole trade so you know how much money you’ll receive up-front.
Once you’ve established that your online brokerage supports multi-leg orders, find a stock that you think will stay within a range over the next month or two.
Make sure you also identify the upper and lower limits of the trading range. That’s important.
Start by selling a call option for a strike price that’s roughly equal to the current stock price. Then, buy an out-of-the-money call option with a strike price that represents the upper limit of the trading range.
After that, sell a put option for the same strike price as you sold the call option. Finally, buy an out-of-the-money put option with a strike price that represents the lower limit of the trading range.
Now you just need to wait until expiration to find out if your trade is profitable.
Keep in mind: with an iron butterfly, time is on your side. That’s because the natural time decay of options eats into the value of your short positions. As they drop in value, you make money.
Real Life Example Using an Iron Butterfly?
Let’s say Apple is trading at $165 per share right now. You think it’s going to stay between $160 and $170 over the next month, so you decide to enter into an iron butterfly trade.
You start by selling the $165 call option. That’s trading for $7.10 right now, so you earn $710 from that sale because options are traded in blocks of 100 shares ($7.10 x 100 = $710).
Next, you buy the $170 call option because $170 is your upper limit on the trading range. That option is going for $4.90 right now so you spend $490 on it ($4.90 x 100 = $490).
After that, you sell the $165 put option for $6.20. That earns you $620 ($6.20 x 100 = $620).
Finally, you buy the $160 put option because $160 is the lower end of your trading range. That option is going for $4.35 right now so you spend $435 ($4.35 x 100 = $435).
Your total credit for the iron butterfly trade is $405 ($710 – $490 + $620 – $435 = $405).
Now, let’s say you were right. At contract expiration, Apple is still trading at about $165 per share. What happens then?
You make money.
First, the options you purchased will expire worthless. That’s okay, though, because you didn’t spend nearly as much on those as you earned from your sale of the at-the-money options.
At contract expiration, if Apple is trading just under $165 then the call option you sold will also expire worthless. You keep all the money you made from it.
However, the put option will have some value. Not much, though.
Let’s say you have to buy back the put option for $1 per contract. That will cost you $100 ($1 x 100 = $100).
The overall trade is still profitable. Remember, you earned $405 from the whole iron butterfly trade at the beginning. If you have to buy back a slightly in-the-money put option for $100, then your profit is $305 ($405 – $100 = $305).
What Are Similar Strategies Related to Iron Butterfly?
Here are a few strategies related to iron butterfly:
- Iron Condor – Similar to an iron butterfly except it involves an out-of-the-money short put spread and an out-of-the-money short call spread.
- Bear Call Spread – Involves buying an out-of-the-money call option and selling an in-the-money call option for a credit. It’s a profitable trade if the underlying stock drops in value prior to expiration.
- Bull Put Spread – Involves buying an out-of-the-money put option while selling an in-the-money put option for a credit. It’s a profitable trade if the underlying stock increases in value prior to expiration.
Iron Butterfly Compared to Other Options Strategies?
As with many other options strategies, iron butterfly offers both limited risk and limited return.
That means you can’t “let your winners run” with this strategy. It’s going to give you a maximum profit and that’s it.
Because you have short positions in the trade, time works on your side. The options that you sell up-front will erode in value, all other things being equal, as the contract gets closer to expiration. So you make money when the underlying stock stays flat.
However, iron butterfly involves four legs. It’s significantly more complicated than many other options strategies.
Make sure that you do plenty of practice trading before you open an iron butterfly trade for real. It’s easy to make a mistake that could be costly.
Advantages & Risks of Iron Butterfly?
- Up-front credit – You get money deposited to your account right away with an iron butterfly. That could make a difference if the time value of money is important to you.
- Limited risk – Because you’re hedged on both ends of the trade, your risk is limited.
- Complicated strategy – Iron butterfly is a four-legged strategy that only the most experienced options traders should use.
- Limited return – Not only is your risk limited, but your return is limited as well.