Iron Butterfly Definition
An iron butterfly is a limited risk strategy involving four option contracts to earn a limited profit if prices move within the selected range. This options trading strategy is suitable for a less volatile market and keeps traders’ investments stable.
Traders use this strategy when they anticipate little change in the underlying asset price until the option contracts’ expiry. Iron butterfly consists of four options trades – a bear call spread, a bull put spread, a short call, and a short put options with the same expiry date. Seasoned investors utilize iron butterfly to limit their unlimited risk while making a limited profit. Iron fly is another name for this strategy.
Table of contents
- Iron butterfly is an options trading strategyOptions Trading StrategyOptions trading refers to a contract between the buyer and the seller, where the option holder bets on the future price of an underlying security or index. designed to help identify a target priceTarget PricePrice Target in the context of stock markets, means the expected valuation of a stock in the coming future and the valuation may be done either by the stock analysts or by the investors themselves. For an investor, price target reflects the price at which he will be willing to buy or sell the stock at a particular period of time or mark an exit from their current position. and put and call positions within a specific value range to ensure limited risk and profit.
- The three strike prices that investors select include the target price or the middle strike and lower and higher strike prices.
- If applied on a not-so-volatile market, the iron fly strategy would assist traders in garnering maximum profits if the stock prices stop at the middle strike price. In addition, it also makes them incur a low loss by hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market. against the risk of price fluctuations.
- The iron fly strategy restricts a trader’s profit and loss by maintaining a better risk to reward ratio. Many experts have suggested that this strategy works best with a seasoned trader who can efficiently balance all the elements.
How Does Iron Butterfly Option Strategy Work?
- Trading with options allows traders to make profits from the stock price movements. Call and put are two central elements of options trading. The call option holder has the right to buy an asset for which the call buyer has paid a premium at a strike price. Until the contract’s expiry, if the stock price goes beyond the strike price, the call buyer will profit while the call seller will incur a loss.
- A put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated. holder buys an option at a strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. by paying a premium. The put buyer holds the right to sell it until expiry. If the stock price falls below the strike price, the put buyer who is now a put seller will profit when selling. The put buyer will incur a loss.
- Trading experts often combine call and put options to limit risks and make profits. Amongst other trading strategies of options, the iron butterfly is a popular one. The iron fly allows traders to trade four different option contracts at three strike prices, including higher, middle, and lower. It comprises two call and put options. Together, they make a butterfly on the trading chart.
- The body depicts the selling of one put option and one call option at the same middle strike price (target price). The wings represent buying put and call options. The put option is bought below the target price while the trader purchases the call option above it. They all have the same expiry date. Iron butterfly transactions involve a spread trading strategy where call and put options are combined.
- Traders apply the iron fly strategy when they speculate that a stock will trade within a limited price range in a less volatile market. The investors, especially the retail traders, enjoy maximum profits when the asset closes on the middle strike price or the target price. They, however, start incurring heavy losses as soon as the asset prices reach or move beyond their selected range. The iron fly strategy can be short and long.
How To Apply Iron Butterfly Strategy
Iron butterfly is an advanced options trading strategy that can yield higher profits if the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. price equals the middle strike value at expiration. An investor can apply the tactic in the following steps:
- Identify a target price for the underlying asset at a strike price.
- Sell call and buy options at the stock’s current price by selling at the at-the-money price. The strike price becomes the target or the middle strike price.
- Buy out-of-the-moneyOut-of-the-money”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value. (OTM) put option that should be lower than the target price. It becomes the lower strike price. Buying the OTM put increases a trader’s risk.
- Buy out-of-the-money (OTM) call option higher than the target price. It becomes the higher strike price. Buying the OTM call increases a trader’s risk.
- OTM purchases here are giving a cushion against unlimited losses.
The strategy creates an opportunity wherein traders can reap smaller limited profits or incur lower maximum potential losses. The calculation of each scenario goes as follows:
Smaller Maximum Profit or Net Credit = Call Option Sold + Put Option Sold – Put Option Purchased – Call Option Purchased
Lower Maximum Loss Possible = Spread – Net Credit
Let us consider that the stock of Clove Inc. is trading at $50 in May 2021. A trader named Mark is interested in making some profit out of it using the iron butterfly strategy.
Mark sells a put option at the middle strike price of $50 (target price) at a premium of $5. He also sells a call option at the same strike price. He pays a premium of $4.
He then decides to purchase a put option at a lower strike price of $40 at the premium of $1.50.
Next, he purchases a call option at a higher strike price of $60 by paying $1.75. The cushioning against the unlimited risk will come through these two purchases.
- Smaller Maximum Profit or Net Credit = $5 + $4 – $1.75 – $1.50 = $8.75
- The spread is $10, as $60 – $50 = $50 – $40, i.e. 10.
- Lower Maximum Loss Possible = $10 – $8.75 = $1.25
The breakeven points that talk about risk making positions in an iron butterfly strategy are as follows –
- Target Price + Net Credit = $50 + $8.75 = $58.75
- Target Price – Net Credit = $50 – $8.75 = $41.25
One will start incurring a heavy loss if the stock price rises to and beyond $ 58.75. Similarly, one would begin incurring a heavy loss if the stock price goes down to $41.25 and beyond.
As long as the price stays in the above range or at the target price, one would profit.
Alice is a seasoned iron fly investor. She decides to buy put and call options. First and foremost, she starts by identifying the at-the-moneyAt-the-moneyATM refers to a situation in which the option holder's exercise of the option results in no loss or gain since the exercise price or strike price is equal to the current spot price of the underlying security. target price. Two more OTM strike prices follow next. They all share the same expiry. She then buys put and call options. The price fluctuates beyond her safety net but soon enough comes back due to less volatility bringing her profit.
Iron Butterfly vs Iron Condor
Both iron butterfly and iron condor are options trading strategies and have their own set of pros and cons.
The iron butterfly strategy uses four options with three strike prices for low risk and limited-profit chances. The iron condorIron CondorIron Condor is a derivative strategy designed to earn profit in a limited loss and a limited profit basis. It consists of four options – long call, short call, long put and a short put, all with the same expiration date, however, are of different strike prices. also utilizes four options available to traders with two put spreads and two call spreads but at four different strike prices.
The stock price movement stops and closes at the target strike price, in such a case, the returns from the iron butterfly technique are usually higher.
Let us have a look at the differences between the two strategies.
|It has an at-the-money target strike price.
|It usually has a slightly out-of-the-money target stick price.
|Three strike prices.
|Four strike prices.
|Maintains better reward to risk ratio.
|More likely to gain profits.
Frequently Asked Questions (FAQs)
An iron butterfly strategy is adopted to hedge against potential risk to achieve a profit. By adopting this strategy, traders can select three strike prices within a specific level. They make profits if the stock prices fall within the range or limit their losses when they go beyond.
Considering the target price, traders can adjust their put and call spreads easily using their preferred tools. It will help them know the cost they will gain or lose due to price fluctuations.
With the narrow structure of the pattern, one assesses the risk beforehand. Traders may have to bear some losses while expecting considerable profits. It is a good strategy in the sense of providing hedging to limit the losses.
This has been a guide to What is Iron Butterfly & its Definition. Here we discuss how does it work and how to apply along with examples. You may also have a look at the following articles to learn more –