Options traders use the iron butterfly strategy during neutral market conditions as it is designed to produce a profit when volatility declines. The trade consists of four option contracts at three different strike prices. The first important part of making this trade successful is to predict when the market will trend towards less volatility. As with all trades, it is important to know how to exit this trade. You may see this trade referred to as an “Iron Fly” instead of an iron butterfly.
What Does Iron Butterfly Mean?
You will set up this trade to profit when stock prices move within a narrow range during times when volatility is declining. It is basically a short straddle with the addition of a long put option and a long call option. Because this trade can provide a small profit, traders need to pay attention to fees and commissions so that they don’t eat up the profits. And, one of the outcomes of this trade may be that you end up buying the stock after expiration.
How an Iron Butterfly Works
The iron butterfly consists of two call options and two put options. All of them have the same expiration date. However, the trades are at three separate strike prices. Think of this trade as a short straddle at the middle strike price with a long strangle at the upper and lower strike prices. The maximum profit with this trade happens when the stock closes exactly at the middle strike price at expiration of the contracts. Here is how to set up the trade.
- Identify a target price at which you believe the stock will close at a given future date
- Pick options that will expire at or near the date you have chosen
- Buy a call option with a strike price above your target price (expected to be out of the money at expiration)
- Sell a call and a put at a strike price at or near your target price
- Buy a put option at a strike price below the target price.
The call option at the top price protects against loss if the stock moves above your targeted price range. The put option at the lowest strike price protects against loss if the stock moves below your targeted price range. The upper and lower strike prices need to be far enough apart to allow for a reasonable and predictable amount of price movement. The profit comes from the difference between the premiums gained for selling the call and put at the middle strike price minus the costs for the out-of-the-money call and put at the upper and lower end of this trade minus fees and commissions.
Profit or Loss from an Iron Butterfly
This trade can be set up for a guaranteed but small profit. The setup is important because excessive fees and commissions for the four contracts can eat significantly into profits. Professionals use this trade in markets that are “trading sideways.” There are two worst case scenarios with this trade. One is that you are sloppy when setting it up and even the ideal scenario provides very little profit. The other is that you miss a big market movement either up or down and are sitting there with a small profit instead of a big one. And, if the market moves unexpectedly and you are not able to exit the upper or lower contract in time, you may end up buying and holding the stock in question.
As with all options trading, experience helps. Become a member of Top Gun Options, learn from the pros, and get trade setups that will make money for you no matter what.