Long Iron Butterfly Strategy - Credit Spreads on Steroids
The long iron butterfly is another range trading strategy and a variation of the Iron Condor. Both these strategies use a combination of two credit spreads facing opposite directions, one using calls, the other puts.
The difference between the two is the range of option strike prices used - the Iron Condor has four different strike prices and uses 'out of the money' sold options for the 'body' of the setup, whereas the Long Iron Butterfly focuses on using the same 'at the money' short (i.e. sold) strike prices for the 'body' and two long 'out of the money' options for the 'wings'. As a consequence, the iron butterfly brings in a greater credit due to the higher priced ATM options being sold, but also involves a greater risk that the stock will penetrate the wings, because they will usually be closer to the current trading price of the underlying stock at the time of entry.
Butterfly vs Long Iron Butterfly
We also need to distinguish between the concept of a Butterfly Spread and a Long Iron Butterfly. The former uses either all calls or all put options and comprises an adjacent credit spread and a debit spread together, usually resulting in a net debit to your account. The Iron Butterfly however, uses two credit spreads - a 'bear call' and a 'bull put' spread. These two credit spreads are what creates the 'iron' part of these strategies. The idea is that you are bringing in a double premium and a net credit in the knowledge that whatever happens from here, only ONE of the credit spreads can lose if you let them run to expiry.
Let's take an example to illustrate
XYZ stock is currently trading at $20, therefore options with a $20 strike price will be 'at the money'. We believe this stock will continue to trade within the range of $15 - $25 by the time our positions will expire. We use the same amount of option contracts for all positions.
1. Bear Call Credit Spread
SELL $20 'at the money' call options
BUY $25 'out of the money' call options
2. Bull Put Credit Spread
SELL $20 'at the money' put options
BUY $15 'out of the money' put options
From the above we can see that we have taken out four options positions simultaneously, with a common ATM $20 strike price for calls and puts, to form our Iron Butterfly - but breaking it down, we have two credit spreads.
Characteristics of the Long Iron Butterfly
Limited Risk: Your risk is the difference between ONE of the strike prices on either side of the middle strike prices, (the 'body' of the butterfly), LESS the premium you have received from selling both 'at the; money' call and put options. If option volatility is working in your favour at the time you take the trade, this risk can be minimal.
Limited Reward: Your profit is limited to the premium you take in from selling 'at the money' options.
Collateral Required: Normally for credit spreads, you will need sufficient funds in your broker account to cover the difference between strike prices, times the number of shares the option contracts cover. However, since it is only possible for one of your positions to be unprofitable at expiry, some brokers may take this into consideration and allow you to only allocate funds necessary to cover one side of the spread.
First, you identify a stock that you believe will be range bound at least until the expiry date of your long iron butterfly position.
Second, you should examine the current market prices relative to the option strikes necessary to establish the strategy. Organize these into a table and evaluate the 'risk to reward' ratio before placing the trade. The basic idea is, to take advantage of option prices that will allow you to get into the trade for a maximum credit in comparison to the potential risk at expiry. For example, if you see an Iron Butterfly opportunity following a large move, option implied volatility may work in your favour so that your sold positions relative to your OTM bought ones result in a risk to reward ratio of over 1000 percent.
You do not need to wait until expiry date to exit your position. Providing the stock remains within the range you anticipate, this allows you some flexibility as the options approach expiry date. You simply evaluate the profit level within the final two weeks and exit when the market price of the underlying is closest to your 'at the money' positions.
However, if the price of the underlying should surge away in either direction and breach the outer strike prices, you can do one of two things. Either exit the position to ensure you are not assigned the underlying shares, or ... depending on where you think the stock may go from here, you could take advantage of a nice characteristic of credit spreads and roll out the losing position to a later expiry month, while letting the other side of the credit spread expire without risk.