The iron butterfly spread is a limited risk,
limited profit trading strategy that is structured for a larger probability of
earning a smaller limited profit when the underlying
stock is perceived to have a
low volatility.
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Iron Butterfly Construction
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Buy 1 OTM Put
Sell 1 ATM Put Sell 1 ATM Call Buy 1 OTM Call |
To
setup an iron butterfly, the options trader buys a lower strike out-of-the-money put, sells a
middle strike at-the-money put, sells a middle strike
at-the-money call and buys another higher strike out-of-the-money call. This
results in a net credit to put on the trade.
Limited Profit
Maximum profit for the iron butterfly strategy
is attained when the underlying stock price at expiration is equal to the
strike price at which the call and put options are sold. At this price, all the
options expire worthless and the options trader gets to keep the entire net
credit received when entering the trade as profit.
The formula for calculating maximum profit is
given below:
- Max Profit
= Net Premium Received - Commissions Paid
- Max Profit
Achieved When Price of Underlying = Strike Price of Short Call/Put
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Iron Butterfly Payoff Diagram
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Limited Risk
Maximum loss for the iron butterfly strategy is
also limited and occurs when the stock price falls at or below the lower strike
of the put purchased or rise above or equal to the higher strike of the call
purchased. In either situation, maximum loss is equal to the difference in
strike between the calls (or puts) minus the net credit received when entering
the trade.
The formula for calculating maximum loss is
given below:
- Max Loss =
Strike Price of Long Call - Strike Price of Short Call - Net Premium
Received + Commissions Paid
- Max Loss
Occurs When Price of Underlying >= Strike Price of Long Call OR Price
of Underlying <= Strike Price of Long Put
Breakeven Point(s)
There are 2 break-even points for the iron
butterfly position. The breakeven points can be calculated using the following
formulae.
- Upper
Breakeven Point = Strike Price of Short Call + Net Premium Received
- Lower
Breakeven Point = Strike Price of Short Put - Net Premium Received
Example
Suppose XYZ stock is trading at Rs40 in June. An
options trader executes an iron butterfly by buying a JUL 30 put for Rs50,
writing a JUL 40 put for Rs300, writing another JUL 40 call for Rs300 and
buying another JUL 50 call for Rs50. The net credit received when entering the
trade is Rs500, which is also his maximum possible profit.
On expiration in July, XYZ stock is still
trading at Rs40. All the 4 options expire worthless and the options trader gets
to keep the entire credit received as profit. This is also his maximum possible
profit.
If XYZ stock is instead trading at Rs30 on
expiration, all the options except the JUL 40 put sold expire worthless. The
JUL 40 put will have an intrinsic value of Rs1000. This option has to be bought
back to exit the trade. Thus, subtracting his initial Rs500 credit received,
the options trader suffers his maximum possible loss of Rs500. This maximum
loss situation also occurs if the stock price had gone up to Rs50 or beyond
instead.
To further see why Rs500 is the maximum possible
loss, let’s examine what happens when the stock price falls below Rs30 to Rs25
on expiration. At this price, only the JUL 30 put and the JUL 40 put options
expire in-the-money. The long JUL 30 put has an intrinsic value of Rs500 while
the short JUL 40 put is worth Rs1500. Selling the long put for Rs500, and
factoring in the intial credit of Rs500 received, he still need to fork out
another Rs500 to buy back the short put worth Rs1500. Thus his maximum loss is
still Rs500.
Disclosure/Disclaimer and FAQ
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