Flying Heavy With an Iron Butterfly
In our previous post, we talked about using iron condors. It’s a lot to breakdown, but here are the basics: sell 1 out-of-the-money bear call spread and sell 1 out-of-the-money bull put spread. We receive a net credit and hope the stock does not appreciate past our break-even prices.
A long iron butterfly works in a similar manner. However, rather than utilizing out-of-the-money call and put spreads, we are using at-the-money spreads.
How it Works
An investor is eyeing shares of ABC, which trades at $55. To enter a long iron butterfly, the investor would sell the $55 call and the $55 put. In an iron butterfly, the investor must sell short the two options at the same strike price.
From there, the investor would buy an out-of-the-money call option and an out-of-the-money put option, in this case buying the $60 call and buying the $50 put options. You’ll notice that our long options are an equal distance from the short call and short put options.
Our maximum profit is realized if the stock closes at exactly our short strike price. In the case of ABC, our maximum profit would be realized if the stock closed at $55 on expiration day.
For clarity, let’s assign some numbers to our example. ABC is trading at $55 and expiration is in four weeks.
Sell the $55 call for $1.15
Buy the $60 call for $0.15
Net Credit: $1.00
Sell the $55 put for $1.15
Buy the $50 put for $0.15
Net Credit: $1.00
The total trade results in a net credit of $2.00. At first glance, that looks pretty good, given we are working with a $5.00 spread. But when considering that it’s highly unlikely we’ll achieve our maximum profit, some investors might be asking themselves, “Why would I ever enter this position?”
That’s an understandable question. But considering the risk/reward, it’s actually not too bad. Our maximum risk is $3.00 — which is the $5.00 spread minus our net credit of $2.00 — while or maximum reward is $2.00. That’s not all bad.
Our break-even price in this trade would be at $57 and $53. We achieve this by subtracting our $2.00 credit from our short $55 put and adding it to our short $55 call. The closer the closing expiration price is to $55, the more of our net credit we get to keep.
Our maximum loss is $3.00, which happens if the stock closes at or above $60, or at or below $50 on expiration. Our losses are capped here due to our long call and put options, respectively.
Here’s a few examples, followed by a chart:
With the stock at $58, we have a net loss of $1.00
$58 stock price – $55 short call = $3.00 loss + $2.00 premium collected = $1.00 total loss
With the stock at $54, we have a net gain of $1.00
$54 stock price – $55 short call = $1.00 loss + $2.00 premium collected = $1.00 total gain
With the stock at $57, we have no gain or loss
$57 stock price – $55 short call = $2.00 loss + $2.00 premium collected = $0 gain
A Real World Example
Now that we’ve got an understanding of how a long iron butterfly is structured, let’s take a closer look at a real world example.
While the return on risk options are attractive, the total loss probability and target return probabilities are not what we are used to. In short, we like to minimize the likelihood of total loss and maximize our target return probability.
When using long iron butterflies though, those numbers move in the opposite direction. That’s not because it’s a terrible strategy. It’s just that the way the iron butterfly is structured — short two at-the-money options — that a move in either direction instantly changes the profit/loss situation.
Unless the underlying security closes at exactly the short strike prices, we cannot achieve our maximum return.
So let’s take a look at our specific trade. In this case, we went with the top result as chosen by Option Party’s Party Rank feature. In the shot above, this can be seen on the farthest right column, which ranks the QQQ as the No. 1 option.
In this case, it involves selling the $130/$119.50 bull put spread while simultaneously selling the $130/$140.50 bear call spread. For doing so, we’ll collect a net credit of $6.33.
Our net credit of $6.33 is also our maximum profit, but it requires the QQQ to close at exactly $130, which is unlikely. So we should know that our break-even price is our short strike price, plus and minus our net credit.
That means that on a QQQ rally, our break-even price is $136.33 and our break-even on the downside is $123.67. Since the stock can’t close above $140.50 and below $119.50 simultaneously, our maximum loss only needs to be calculated on one front. Meaning, on the bear call spread or the bull put spread.
In that case, our maximum loss on the upside is realized on a close at or above $140.50 on expiration. On the downside, or maximum loss is realized on a close at or below $119.50 on expiration.
Our maximum loss is $4.17, which is calculated as such:
$140.50 – $130 = $10.50; $10.50 – $6.33 = $4.17
$130 – $119.50 = $10.50; $10.50 – $6.33 = $4.17
The long iron butterfly isn’t for everybody and it’s not for every scenario. But in unique situations, this unique and complex options trade could have a fitting place within a trader’s toolbox.