Trading in options can be extremely interesting. That’s because there are numerous trading strategies that are exclusive to these financial assets. Among the many strategies out there, the iron butterfly is one such technique that’s unique and requires a bit of effort to understand. But that said, once you get your basics about this options trading strategy right, it’s easier to understand and execute this technique with a bit of practice.
So, without further ado, let’s get to know the basics of the iron butterfly option strategy.
What is the iron butterfly strategy?
Like the iron condor, the iron butterfly is also an options trading strategy that involves the use of both call options and put options. It basically revolves around four options, each with the same date of expiry, just like the iron condor strategy.
To execute an iron butterfly strategy, here are the four trades that you need to execute.
– But a put option at strike price A
– Sell a put option at strike price B
– Sell a call option at strike price B
– Buy a call option at strike price C
Here, all the three strike prices are equidistant, and are in order of increasing value: A, B, C. For instance, strike prices A, B, and C could be Rs. 100, Rs. 200, and Rs. 300 respectively. We’ll get into these details in a bit, when we take up an example.
As you can see, the iron butterfly strategy involves the use of four simultaneous legs of trading. This four-part strategy includes a bull put spread and a bear call spread.
Let’s now look at an example to understand this trading strategy better.
The iron butterfly option strategy: An example
Let’s assume that the shares of a company are trading at Rs. 100. Here are the four trades that you can execute to construct an iron butterfly. Say all the options given below have a lot size of 100 shares.
You buy one put option with a strike price of Rs. 95 (at a cost of Rs. 120)
You sell one put option with a strike price of Rs. 100 (for a price of Rs. 320)
You sell one call option with a strike price of Rs. 100 (for a price of Rs. 330)
You buy one call option with a strike price of Rs. 105 (at a cost of Rs. 140)
So, at the outset, your overall gain is Rs. 390 (since you received Rs. 650 for the options sold and paid Rs. 260 for the options bought). This means you have a net credit overall.
Now, at expiry, if the price of the underlying stock closes at the strike price of the short options (i.e. at Rs. 100), here’s what will happen.
Option 1 would expire worthless, since it gives you the right to sell at Rs. 95 (instead of Rs. 100)
Option 2 would expire worthless, since it gives the buyer the right to sell at Rs. 100 (which is the same as the market price)
Option 3 would expire worthless, since it gives the buyer the right to buy at Rs. 100 (which is the same as the market price)
Option 4 would expire worthless, since it gives you the right to buy at Rs. 105 (instead of Rs. 100)
So, all things considered, you will be left with the initial gain of Rs. 390 if you follow the iron butterfly strategy in this scenario.
On the other hand, if the stock closes below the lower strike price or above the higher strike price, there’s greater risk of loss. This is why the iron butterfly option strategy is better suited for scenarios where the market is not highly volatile.
Like the iron condor strategy, the iron butterfly is also better suited for veterans and experienced traders. Here, when the stock price is exactly at the center strike price, the gains are at their highest. Clearly, the sweet spot in this technique is very narrow, so it takes a great deal of expertise to get this options trading strategy right. Therefore, if you’re only just beginning options trading, it’s better to take your time and build up on your expertise before attempting this technique. Additionally, this strategy isn’t the best option in volatile market conditions, since the probability of the options expiring at the right price become slimmer when the stock price is fluctuating greatly.