Options are defined as being instruments of finance that are derivatives. Alternatively, they draw from underlying securities, which include stocks among other things. An options contract provides the buyer with the chance to buy or sell the underlying asset. This depends entirely on the type of contract that they are holding. In contrast to futures, there’s no requirement for the holder to buy or sell the asset if they don’t want to.
Call options permit the holder to purchase the asset at a price residing within a specific timeframe. Conversely, put options allow the holder to sell the asset at a price within a specific timeframe.
Generally speaking, options offer an array of strategies for making money that cannot be subject to duplication with conventional securities. Moreover, not all option trading types are what one may call “high risk.”
Let’s take the ‘iron butterfly’ strategy for example. It is a trading method that possesses the capability of generating a steady income. What’s more, it can accomplish this while establishing a dollar limit on the profit or loss.
What is it?
In finances, an ‘iron butterfly’ (also the ‘ironfly’) is the name of an advanced options trading strategy and is neutral-outlook. It typically involves purchasing and holding four different options at three separate strike prices.
The iron butterfly is a trading strategy that is limited-risk and limited-profit. Not only that, but it also has a structure specifically for a better likelihood of earning a smaller limited profit. This is possible when there is speculation that the underlying stock has a low unpredictability.
This is the formula for solving for the ironfly:
ironfly = △(butterfly strike price) x (1 + rt) – butterfly
This strategy is a member of a specific group of option strategies: ‘wingspreads.’ It has this name on account of each strategy having a name that derives from a flying creature. Such titular creatures include a butterfly or a condor.
The creation of this strategy comes from the combination of a bear call spread with a bull put spread. Additionally, there is an identical expiration date that assembles at the middle strike price. Both a short call and put are sold at the middle strike price, which constructs the ‘body’ of the butterfly. The purchase of a call and put are above and below the middle strike price, respectively. This effectively forms the butterfly’s ‘wings’.
Differences from the basics
The iron butterfly strategy diverges from the basic butterfly spread in two key ways. First of all, the iron butterfly is a credit spread that pays the investor a net premium at open. The basic butterfly position, however, is a type of debit spread. Second of all, the iron butterfly requires a total of four contracts rather than three.
Let’s say, for instance, that a company rallied to $50 in August. Moreover, let’s assume that the trader wants to employ an iron butterfly as a means to produce profits. They will write both a September 50 call and put, thus obtaining $4.00 of premium for each contract. Additionally, they purchase a September 60 call and September 40 put, each for $0.75. The net result is an immediate $650 credit following the subtraction of the price paid for the long positions. This subtraction is from the premium that the short ones receive, which is $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
The short strategy
A short iron butterfly option strategy attains maximum profit when the underlying asset’s price upon expiration equates to the strike price. At which point, the call and put options are then put up for sale. Following this, the trader will obtain the net credit of entering the trade once the options are worthless upon lapsing.
This particular option strategy typically consists of the following options. Keep in mind that X = the spot price (i.e. the current market price of underlying) and a > 0.
- Long one out-of-the-money put: strike price of X − a
- Short one at-the-money put: strike price of X
- Short one at-the-money call: strike price of X
- Long one out-of-the-money call: strike price of X + a
The standard long iron butterfly will obtain maximum losses whenever the stock price falls either at or below the lower strike price of the put. Alternatively, whenever the stock price exceeds or is equal to the higher strike of the call that one may purchase. The difference in strike price between the calls or puts subtracted by the premium one gets when entering the trade is the acceptable maximum loss.
The basic formula for the calculation of the maximum loss is the following:
- Max Loss = Strike Price of Long Call − Strike Price of Short Call − Premium
- Max Loss Occurs When Price of Underlying >= Strike Price of Long Call OR Price of Underlying <= Strike Price of Long Put
Using the strategy
The iron butterfly places limits on both the potential gain and potential loss. Their overall design allows traders to be able to keep at least some of the net premium that is initially paid. This occurs whenever the price of the underlying security or index concludes in between the upper and lower strike prices.
Market players utilize this strategy if they presume that the underlying instrument will remain within a given price range. Specifically, through the options’ date of expiration. The closer to the middle strike price the underlying closes upon expiration, the higher the profit becomes.
The trader will acquire a loss should the price close above the strike price of the upper call, Alternatively, if it closes below the strike price of the lower put. The breakeven point is determinable by adding and subtracting the premium you receive from the middle strike price.
In the example from before, the calculation of the breakeven points goes as follows:
- Price of the middle strike = $50
- The net premium payment upon open = $650
- Upper break-even point = $50 + $6.50 (x 100 shares = $650) = $56.50
- Lower break-even point = $50 – $6.50 (x 100 shares = $650) = $43.50
Now, let’s imagine that the price ends up rising above or below the breakeven point. In this case, the trader pays more to purchase back the short call or put than what they initially receive. This will inevitably result in a net loss.
Building on the example
To go more into this, imagine that the company from before closes at $75 in November. This means that all of the options residing in the spread will be worthless upon expiration, excluding the call options. Thus, the trader must buy back the short $50 call for $2,500 ($75 market price – $50 strike price x 100 shares). This is so that they can close out the position. Moreover, they can pay for a corresponding premium of $1,500 on the $60 call ($75 market price – $60 strike price = $15 x 100 shares).
In the end, the net loss on the calls will equal out to be $1,000. It will be subject to subtraction from the initial net premium of $650 for a final net loss of $350.
Obviously, it’s not mandatory for the upper and lower strike prices to be equally distant from the middle strike price. The creation of iron butterflies can come with a bias that leans towards one direction or the other. To elaborate, wherever the trader believes the underlying will rise or fall slightly in price. However, this is only to a specific level. Let’s assume that the trader believes that the company will rise to $60 by expiration. If this is the case, then they can raise or lower the upper call. Alternatively, they can lower put strike prices accordingly.
One can invert the iron butterfly so that they can take long positions at the middle strike price. Consequently, short positions are put into place at the wings. This can be profitable during periods consisting of high volatility within the underlying instrument.
Advantages & Disadvantages
There is an array of benefits that iron butterflies provide for users. Their creation can stem from the utilization of a small amount of capital. Moreover, it supplies a stable income with considerably less risk than directional spreads. They can also be subject to rolling up or down, not unlike other spreads. This can occur should the price start to move out of the range. Alternatively, traders can decide to close out half of the position, thus profiting on the remaining bear call or bull put spread.
Additionally, the parameters of risk and reward are clearly defined. The payment of the net premium is the maximum possible profit that the trader can reap from this strategy. The ultimate difference between the net loss in the midst of the long and short calls or puts minus the initial premium paid is the maximum possible loss the trader can acquire.
It is a wise idea to keep track of commission costs on iron butterflies. This is because there are four positions that have to have an opening and closing. Furthermore, it’s rare to earn the maximum profit. This is due to the underlying often settling between the middle strike price and either the upper or lower limit. What’s more, the odds of incurring a loss are relatively higher. The reason for this being that the creation of most iron butterflies comes from utilizing narrow spreads.
The purpose of iron butterflies is to provide traders and investors with a steady income, all while limiting risk. Even so, this type of strategy is really only appropriate with an intensive grasp on both the risks and rewards. A good chunk of brokerage platforms needs clientele that applies either this or other similar strategies. Doing so will effectively achieve a specific skill level and certain financial requirements.