User:Nickaveni125/sandbox

Iron Butterfly Stub

In finance an iron butterfly, also known as the ironfly, is the name of an advanced, neutral-outlook, options trading strategy that involves buying and holding four different options at three different strike prices. It is a limited-risk, limited-profit trading strategy that is structured for a larger probability of earning smaller limited profit when the underlying stock is perceived to have a low volatility.

To set up 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, hence it is a credit spread.

If there is no arbitrage, the butterfly and iron butterfly have the following price relationship:

Investor anticipation is that the price of the underlying asset will move dramatically during the life of the options purchased or sold. The movement of the price can be either positive or negative. The Investor will profit when the price of the underlying asset is outside of the wings of the Iron Butterfly. A maximum loss would be procured when the price of the underlying asset is at the body of the butterfly upon expiration. All the options contracts would expire worthless and the loss taken would be the premium paid for the execution of the strategy. A maximum gain would be procured when the price of the underlying asset is outside the wings of the butterfly upon expiration. In this case either both of the calls or both of the puts would be in-the-money and the profit would be the difference between the body of the butterfly and either wing minus the premium paid to execute. An increase in implied volatility would have a positive impact on this strategy. The passage of time will have a negative impact on this strategy due to the theta decay of an option contract.

Example: ABC Company is trading at $50 in August. Eric wants to use an iron butterfly to profit on this stock. He writes both a September 50 call and put and receives $4.00 of premium for each contract. He also buys a September 60 call and September 40 put for $0.75 each. The net result is an immediate $650 credit after the price paid for the long positions is subtracted from the premium received for the short ones ($800-$150).

Premium received for short call and put = $4.00 x 2 x 100 shares = $800

Premium paid for long call and put = $0.75 x 2 x 100 shares = $150

$800 - $150 = $650 initial net premium credit

Advantages and Disadvantages: Iron butterflies provide several key benefits for traders. They can be created using a relatively small amount of capital and provide steady income with less risk than directional spreads for those who use them on securities that close within the spread price. They can also be rolled up or down like any other spread if the price begins to move out of this range, and investors can close out half of the trade and profit on the remaining bear call or bull put spread if they so choose. Their risk and reward parameters are also clearly defined. The net premium paid at open is the maximum possible profit that the investor can reap from this strategy, and the difference between the net loss reaped between the long and short calls or puts minus the initial premium paid is the maximum possible loss that the investor can incur as shown in the example above.

But investors need to watch their commission costs for this type of trade as four separate positions must be opened and closed, and the maximum possible profit is seldom earned here because the underlying instrument will usually close somewhere between the middle strike price and either the upper or lower limit. And because most iron butterflies are created using fairly narrow spreads, the chances of incurring a loss are proportionately higher.