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Description and use

Long Iron Butterfly option strategy can be profitable if the underlying’s price increases or moves within given levels. It is the combination of the Bull Put Spread and the Bear Call Spread. The combination of two income strategies result another income strategy. The middle Put option’s strike equals to the middle Call option’s strike price. This gives the butterfly shape. Ideally, the share price closes between the middle components’ strike prices, which maximises the profit. The direction of the market is neutral. The investor speculates on shares with low volatility and small price changes. The strategy is a net credit investment. It is a short-term investment, usually one month or less.

  • Type: Neutral
  • Transaction type: Credit
  • Maximum profit: Limited
  • Maximum loss: Limited
  • Strategy: Income strategy, Neutral strategy

Opening the position

Long Iron Butterfly Option Positions

Long Iron Butterfly Option Positions

  • Buy a lower strike (OTM) Put option.
  • Sell a middle (ATM) Put option.
  • Sell a middle (ATM) Call option.
  • Buy a higher strike (OTM) Call option.
  • All components have the same expiration. The strategy uses both Call and Put options. The difference between consecutive strike prices must be equal.

Steps

Entry:

  • Make sure the trend is inclining or stagnating at a certain level.

Exit:

  • The position can be closed before expiration. The commissions should not be forgotten during calculations.

Basic characteristics

Maximum loss: Difference between consecutive strike prices - net credit.

Maximum profit: Received net credit.

Time decay: Time decay has a positive effect on the value when the position is profitable, and a negative effect when the position is lossmaking.

Lower breakeven point: Middle strike price - Net Credit.

Upper breakeven point: Middle strike price + Net Credit.

Advantages and disadvantages

Advantages:

  • The investor can profit from share prices moving within given limits.
  • Low and limited risk with potential income.

Disadvantages:

  • Potentially higher profit is only possible close to expiration.

Closing the position

Closing the position:

  • Buy back the Short options and sell the Long options.

Mitigation of losses:

  • Close the position the above-mentioned way.

Example

Long Iron Butterfly strategy example

Long Iron Butterfly strategy example

ABCD is traded for $25.00 on 12.04.2017. The investor buys a Long Put option which has a strike price of $20.00, expires in May 2017. and costs $0.30 (premium). Then he sells a Short Put option which has a strike price of $25.00, expires in May 2017. and costs $1.50 (premium). Then sells a Short Call option which has a strike price of $25.00, expires in May 2017. and costs $2.00 (premium). Finally, buys a Long Call option which has a strike price of $30.00, expires in May 2017. and costs $0.50 (premium).

Price of the underlying (share price): S= $25.00
Premium (Long Put): LP= $0.30
Premium (Short Put): SP= $1.50
Premium (Long Call): LC= $0.50
Premium (Short Call): SC= $2.00
Strike price (Long Put): KLP= $20.00
Strike price (Short Put): KSP= $25.00
Strike price (Long Call): KLC= $25.00
Strike price (Short Call): KSC= $30.00
Net credit: NCr
Maximum loss: R
Maximum profit: Pr
Lower breakeven point: LBEP
Upper breakeven point: UBEP

Net credit: NCr = (SP + SC) - (LP + LC)
Maximum loss (risk): R = (KSP - KLP) - NCr or R = (KSC - KLC) - NCr
Maximum profit: Pr = NCr
Lower breakeven point: LBEP = KSP - NCr
Upper breakeven point: UBEP = KLC + NCr

NCr = $2.70
R = $2.30
Pr = $2.70
LBEP = $22.30
UBEP = $27.70