Lesson Objective: Understanding Iron Butterflies
| Category | Description | Example |
| Key Components | a) One long (short) put at strike A
b) One short (long) put at strike B, typically ATM c) One short (long) call at same strike B d) One long (short) call at strike C Where A < B < C. All options have the same underlying, same expiration, and the strikes A and C are usually equidistant from B but not necessarily (in which case the iron butterfly is called a “broken” iron butterfly and is taking a directional bias. For the sake of illustration and simplicity, we will consider the case of a short iron butterfly using equidistant strikes, with ATM short options. So, there are one OTM long put and one OTM long call for the outside legs and one ATM short put and one ATM short call for the inside legs. Note that if (instead of using equidistant strikes) strike B is higher than the underlying, then you are bullish. Conversely, if strike B is below the underlying, you are bearish. |
Short iron butterfly (ATM) with the current price of XYZ at $100:
1) Buy one XYZ Jul 20xx $95 Put 2) Sell one XYZ Jul 20xx $100 Put 3) Sell one XYZ Jul 20xx $100 Call 4) Buy one XYZ Jul 20xx $105 Call |
| Why Use Iron butterflies? | Short iron butterflies are used to take advantage of a possible and favorable change in the volatility of the underlying as well as a limited change in the underlying. Another benefit is that the potential profit is fairly high in terms of percentage on the capital at risk (although it is usually small in dollar terms). Finally, risk is limited because the maximum loss is determined at inception. | Short iron butterfly (ATM) with the current price of XYZ at $100:
1) Buy one XYZ Jul 20xx $95 Put 2) Sell one XYZ Jul 20xx $100 Put 3) Sell one XYZ Jul 20xx $100 Call 4) Buy one XYZ Jul 20xx $105 Call |
| When to Use Iron butterflies (outlook)? | Typically, you will use short iron butterflies when anticipating minimal movement in the underlying (if your setup is neutral at inception) while expecting that the volatility of the underlying will decrease during the life of the trade (for instance, after an earnings report has been issued). So, the outlook on the underlying is neutral, and the strategy will be profitable only within a narrow range (if the underlying is close enough to strike B at expiration). If the underlying rises or falls too much, you will incur a loss. | |
| Main Risks or Drawbacks of Using Iron butterflies | Maximum profit is limited.
As expiration approaches, small changes in the underlying can have a high impact on the price of the iron butterfly in terms of percentage (i.e., Gamma is high as you get close to expiration). So, your window for profit is narrow and your profit situation could change dramatically as expiration approaches. In addition, given that there are four legs to this strategy, commissions (and the cost of bid-ask spreads) are typically higher, and risk management is more involved. |
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| The Set Up | Buy one put at a lower strike (strike A), this long put is typically OTM,
Sell one put at a higher strike (strike B), the short put would be ATM in order to receive the highest time (extrinsic) value possible, Sell one call at the same strike (strike B), the short call would also be ATM in order to receive the highest time (extrinsic) value possible, and Buy one call at an even higher strike (strike C), this long call is typically OTM. |
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| Net Credit or Net Debit? | Short iron butterflies are established for a net credit. | |
| Maximum Profit | Maximum profit is limited to the net credit received.
It is reached at expiration when the underlying is exactly at strike B because all the options expire worthless. Note that the likelihood of the underling being exactly at strike B at expiration is slim. |
XYZ at $100:
1) Buy one XYZ Jul 20xx $95 Put for $2 2) Sell one XYZ Jul 20xx $100 Put for $3.5 3) Sell one XYZ Jul 20xx $100 Call for $3 4) Buy one XYZ Jul 20xx $105 Call for $1.5 Net credit of $3 (-$2 + $3.5 + $3 – $1.5) Maximum profit of $3 is reached if XYZ ends at $100 at expiration. |
| Breakeven Prices | There are two breakeven prices:
1) Strike B minus the net credit received 2) Strike B plus the net credit received |
1) Buy one XYZ Jul 20xx $95 Put for $2
2) Sell one XYZ Jul 20xx $100 Put for $3.5 3) Sell one XYZ Jul 20xx $100 Call for $3 4) Buy one XYZ Jul 20xx $105 Call for $1.5 The breakeven points are $97 and $103. |
| Maximum Loss | The maximum loss is equal to the difference between strike B and strike A minus the net credit received.
It is realized at expiration if the underlying is at/below strike A (the calls expire worthless but both puts are ITM), or if the underlying is at/above strike C (the puts expire worthless but both calls are ITM). |
1) Buy one XYZ Jul 20xx $95 Put for $2
2) Sell one XYZ Jul 20xx $100 Put for $3.5 3) Sell one XYZ Jul 20xx $100 Call for $3 4) Buy one XYZ Jul 20xx $105 Call for $1.5 Maximum loss is $2 ($100 – $95 + $3) and is realized when the underlying is either at/below $95 or at/above $105 at expiration. |
| Profit and Loss (P&L) Chart at Expiration | The P&L chart graphically represents the risk profile of a short iron butterfly strategy.
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1) Buy one XYZ Jul 20xx $95 Put for $2
2) Sell one XYZ Jul 20xx $100 Put for $3.5 3) Sell one XYZ Jul 20xx $100 Call for $3 4) Buy one XYZ Jul 20xx $105 Call for $1.5
Note: · The maximum profit of $3 if XYZ is at $100 at expiration · The breakeven points at $97 and $103 · The limited loss of $2 if XYZ ≤$95 or ≥$105 |
| Effect of Price Movements | The long call and the short put have a positive Delta, while the short call and the long put have a negative Delta. Since the strikes of the long OTM options are equidistant to the strike of the short ATM options and both types are of the same total number (2 long options vs. 2 short option), the net Delta remains close to zero for most of the life of the spread. | |
| Effect of Time | The spread has a net positive Theta as long as the underlying stays between strikes A and C. If the underlying moves out of this range, Theta becomes negative as expiration approaches, and then time works against you. | |
| Effect of Volatility | Recall that as volatility increases, the value of long options increases while the value of short options decreases, and vice-versa (all else being equal). So, the effect of implied volatility depends on where the underlying is relative to the strikes.
If the underlying is close to strike B, then the short options carry more weight in determining the net value of the spread. Therefore, the spread will increase in value if volatility deflates. However, if the underlying is near/below strike A or near/above strike C, a rise in volatility will increase the value of the long option to a larger extent than it will decrease the value of the short options, thereby increasing the overall value of the iron butterfly. |
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| Assignment Risk | While the long options have no risk of early assignment, the short options do have such risk. Early assignment on the short call is generally related to dividends, and typically takes place on the day before the ex-dividend date. In-the-money calls for which the extrinsic value is less than the dividend announced have a high likelihood of being assigned. You can assess such risk by looking at the value of the corresponding put (on the pricing chart of your broker), which will provide a good approximation and more direct reading of the time value left in the short calls. If the dividend is higher than the value of the corresponding put, then assignment is likely and action must be taken. | |
| Approval Level Required by Brokers | Usually, the trading of iron butterflies requires a higher level of approval by brokers because of the complexity of risk-managing the position once it has been established. | |
