Iron Butterfly

A long iron butterfly strategy combines a call spread and a put spread; it involves two call legs and two put legs, all with the same expiration date, generally with consistent distances between the 3 strike prices. The strategy gets its name from its 3-part structure, involving the two outer strikes (or "wings") and the middle strike (representing the "body").

Long Iron Butterfly

A long iron butterfly is created by selling a lower strike Put, purchasing both a higher strike Put and Call (middle Put and Call have matching strikes), and selling a consecutively higher strike Call. In order to be considered a standard iron butterfly, the 3 strike prices involved should be equidistant.

Example:

• Sell to Open 1 XYZ 01/17/2015 25.00 Put
• Buy to Open 1 XYZ 01/17/2015 27.50 Put
• Buy to Open 1 XYZ 01/17/2015 27.50 Call
• Sell to Open 1 XYZ 01/17/2015 30.00 Call

If the strike prices are not equidistant from each other, the butterfly is considered to be a "broken wing" butterfly.

The cost to purchase the middle strike Call and Put typically exceeds the premium received from selling the outer strike Call and Put; therefore, a long iron butterfly is typically established as a net debit position.

For use when investor anticipates:

• Significant movement in security price (in either direction)
• Higher volatility

Financial Characteristics:

• Maximum Loss: Difference between middle strike price and outer strike price, less net credit
• Maximum Gain: Initial net credit received

Objective:

• Gain from significant change in price of the underlying security (either up or down) by expiration

EXAMPLE - Long Iron Butterfly

Assume it is July 17th, 2014, and John, an options trader, has identified XYZ as a stock he believes will make a sharp move, either higher or lower, over the next month. Therefore, he decides that a Long Iron Butterfly is an appropriate strategy, given his outlook and the limited risk that the strategy offers. XYZ is currently trading at $34.43, and John decides that 34.00 is an appropriate middle strike; it is around the money and John's outlook is slightly more bearish than bullish. In addition, John feels that the 32.00 and 36.00 strike prices create an appropriate “wingspan,” since he feels that the underlying price will either be below $32.00 or above $36.00 at expiration. Lastly, John selects the August expiration, as it is 30 days away, which is right in line with his timing forecast.

 

Source: StreetSmart Edge

Trade Setup

Here is the breakdown for John's setup and trade:

• Current XYZ Price = $34.43
• Current Bid Price, XYZ 08/16/2014 32.00 Put = $0.11
• Current Ask Price, XYZ 08/16/2014 34.00 Put = $0.60
• Current Ask Price, XYZ 08/16/2014 34.00 Call = $1.07
• Current Bid Price, XYZ 08/16/2014 36.00 Call = $0.26
• John's Trade:
  • Sell to Open 1 XYZ 08/16/2014 32.00 Put @ $0.11
  • Buy to Open 1 XYZ 08/16/2014 34.00 Put @ $0.60
  • Buy to Open 1 XYZ 08/16/2014 34.00 Call @ $1.07
  • Sell to Open 1 XYZ 08/16/2014 36.00 Call @ $0.26
  • Net Debit = -$0.11 + $0.60 + $1.07 - $0.26 = $1.30

The Profit/Loss profile for this trade is as follows:

Note: Chart depicts strategy at expiration

• Maximum Gain = ($34.00 - $32.00) - $1.30 = $0.70
• Maximum Loss = $1.30
• Lower Break-Even = Middle Strike Price - Net Debit = $34.00 - $1.30 = $32.70
• Upper Break-Even = Middle Strike Price + Net Debit = $34.00 + $1.30 = $35.30

Note: Commissions have been excluded to simplify the calculations. Short options can be assigned at any time and therefore option sellers assume the risk of assignment at any point up until and including expiration.

Commissions, taxes, and transaction costs are not included in any of these strategy discussions, but can affect final outcome and should be considered. Please contact a tax advisor to discuss the tax implications of these strategies. Many of the strategies described herein require the use of a margin account.

Qualified Spreads

With a Qualified Spread, the purchased option is required to expire on the same or later expiration date than the option sold. When there is more than one possible way to pair available options in your Account, Schwab has the discretion to determine the spread pairings. Schwab may pair options in a manner that does not produce the lowest possible margin requirements.

Note: For butterfly and condor spreads, each option leg must have the same expiration date to qualify as those types of spreads.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Multiple leg options strategies will involve multiple commissions. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options." Member SIPC