Short Iron Butterfly
You may consider a short iron butterfly when you expect the price of an underlying asset to move near a specific price and want to limit risk.
Construction of the strategy
A short iron butterfly strategy involves trading four options of the same underlying asset.
● Buy a put1
● Sell a put2
● Sell a call1
● Buy a call2
Put1, put2, call1, and call2 have the same expiration date but different strike prices.
Strike price: put1 < put2 = call1 < call2, and put2 - put1 = call2 - call1
Brief description
A short iron butterfly strategy consists of selling a call and a put at the same strike price (middle strike) and buying a put with a lower strike and a call with a higher strike. The lower and higher strike prices are equidistant from the middle strike price. All options have the same expiration date.
A short iron butterfly is also a combination of two strategies: a bear call spread and a bull put spread, or a short straddle and a long strangle.
This strategy has potentially limited maximum profit and limited risk before the contracts expire. You can potentially get the maximum profit if the asset price equals the middle strike price at expiration.
A short iron butterfly has a similar profit-loss chart to the long call/put butterfly strategies. The major difference is that the short iron butterfly is a net credit strategy, while the long call/put butterfly strategies are net debit strategies.
When using this strategy, you should pay attention to the cost (including commissions) because it includes at least four option trades. It is important to ensure a favorable risk/reward ratio.
Gain & Loss
● Breakeven
Upside Breakeven = Middle Strike + Net Premium Received.
Downside Breakeven = Middle Strike - Net Premium Received.
● Max gain
Net premium received
● Max loss
Max Loss= Higher strike - Middle Strike - Net Premium Received
Example
Suppose a theoretical stock called TUTU on Nasdaq is currently trading at $52.
You expect its price would not change too much and would very likely remain at $52 when the options expire. So you decide to use a short iron butterfly:
● Buy a $2 TUTU put with a strike of $48
● Sell a $3 TUTU put with a strike of $52
● Sell a $3 TUTU call with a strike of $52
● Buy a $2 TUTU call with a strike of $56
(The following calculations do not include transaction costs.）
This presentation is for informational and educational use only and is not a recommendation or endorsement of any particular investment or investment strategy. Investment information provided in this content is general in nature, strictly for illustrative purposes, and may not be appropriate for all investors. Read more