Iron Butterfly Spread

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Iron Butterfly Spread - Introduction



So, you wish to profit from a stock that is expected to trade within a tight price range centered around a certain price and wish to also put the advantage of time decay in your favor?

The Iron Butterfly Spread does just that! When you expect the price of the underlying stock to end up at a certain price by expiration but also want to give some allowance on either side for some profit.

The Iron Butterfly Spread is a complex, advanced neutral option trading strategy built upon the foundation of a Butterfly Spread and is a high probability and safe way of profiting from a stock that is expected to stay stagnant or trade within a narrow price range.

Studying the Butterfly Spread first makes the Iron Butterfly Spread easier to understand.

Find Options Strategies With Similar Risk Profiles Find Options Strategies With Similar Risk Profiles

There are some important differences between the Butterfly Spread and the Iron Butterfly Spread though:

1. A Butterfly Spread consists of putting on 3 option trades at once whereas the Iron Butterfly Spread consists of putting on 4 option trades at once in order to attain a higher potential profit than a basic Butterfly Spread. This also makes it more costly for traders with a small fund to put on an Iron Butterfly Spread due to the higher commissions involved in having an extra leg to the position.

2. The Iron Butterfly Spread differs from the Butterfly Spread also in that the Iron Butterfly Spread results in a net credit whereas executing a Butterfly Spread results in a net debit. As a complex credit Spread strategy, most online option trading brokers will not allow beginner option traders to put on an Iron Butterfly Spread due to margin and trading level requiremets. Only veteran traders with high trading levels and a fund big enough to fulfill margin requirements are allowed to put on Iron Butterfly Spreads. Traders need to check with own brokers as to the criteria needed to allow the trading of credit Spreads or Iron Butterfly Spreads.

3. The Iron Butterfly Spread's Profitable Range is also much wider than that of a Butterfly Spread on the same underlying asset at the same strike prices due to the unique combination of 4 option trades instead of just 3.


Overall, the Iron Butterfly Spread is a more advanced option strategy than a Butterfly Spread that results in better profitability, higher probability of profit and a lower maximum possible loss with the trade off being having to put on more trades to establish each position and a much higher margin requirement than a Butterfly Spread.

The Iron Butterfly Spread belongs to the family of complex neutral option strategies, similar to the Condor Spread, Butterfly Spread and Iron Condor Spread. Each of them has their own strengths and weaknesses. Here is a table explaining the differences:

Condor Spread Iron Condor Spread Butterfly Spread Iron Butterfly Spread
Debit/Credit Debit Credit Debit Credit
Max Profit Low High Higher Highest
Max Loss Highest Higher High Low
Cost of Position High NIL Low NIL
Profitable Range Wide Widest Narrow Wider

These comparisons are made with the same maximum and minimum strike prices and real values. As you can see from the table above, all of the above complex neutral option strategies comes with their own strengths and weaknesses. Option trading strategies are all about trade-offs. There are no single option trading strategy that has the best of all worlds.





When To Use Iron Butterfly Spread?


One should use a Iron Butterfly Spread when one expects the price of the underlying asset to change very little over the life of the options.



How To Use Iron Butterfly Spread?


There are 4 option trades to establish for this strategy : 1. Buy To Open X number of Out Of The Money Call Options. 2. Sell To Open X number of At The Money Call Options. 3. Buy To Open X number of Out Of The Money Put Options. 4. Sell To Open X number of At The Money Put Options.

Buy OTM Call + Sell ATM Call + Sell ATM Put + Buy OTM Put



Veteran or experienced option traders would identify at this point that the Iron Butterfly Spread actually consists of a Bear Call Spread and a Bull Put Spread with the short call and put options on the same strike price (at the money).

The choice of which strike prices to buy the long legs (trades 1 and 3 above) at depends on the range within which the underlying asset is expected to trade in (Profitable Range). The further away from the money the 2 long legs are, the lower the risk (as the underlying stock needs to move further in order to exit the profitable range), but the higher the maximum loss would be should the profitable range be exited. Again, this is a trade-off that all option traders need to decide and accept when trading any kind of option strategies.

Iron Butterfly Spread Example

Assuming QQQQ trading at $43.57.

Buy To Open 1 contract of Jan $44 Call at $1.06
Sell To Open 1 contract of Jan $43 Call at $1.63.
Buy To Open 1 contract of Jan $42 Put at $0.59
Sell To Open 1 contract of Jan $43 Put at $0.85.

Net Credit = (($1.63 - $1.06) + ($0.85 - $0.59)) x 100 = $83.00 per position

OppiE's Note Contrast this example with the example in Butterfly Spread. These examples are made using the same QQQQ on the same strike price and real values. You will see that instead of having to pay $18 per position to put on the spread (in the case of a butterfly spread), you actually get $83 for putting on the Iron Butterfly Spread.




Trading Level Required For Iron Butterfly Spread


A Level 4 options trading account that allows the execution of credit spreads is needed for the Iron Butterfly Spread. Read more about Options Account Trading Levels.



Profit Potential of Iron Butterfly Spread :


Iron Butterfly Spreads achieve their maximum profit potential at expiration if the price of the underlying asset is equal to the middle strike price. Maximum profit for the Iron Butterfly Spread is equal to the net credit gained when the position is put on.

Iron Butterfly Spread Profitability

From the above example : Assuming QQQQ close at $43.00 at expiration.
All 4 legs will expire Out Of The Money and you keep the entire net credit amount.

The profitability of an iron butterfly spread can also be enhanced or better guaranteed by legging into the position properly.



Profit Calculation of Iron Butterfly Spread:


Maximum Profit = Net Credit.
Profit % = (Credit Gained From Short Legs / Greatest Difference In Strike) x 100
Maximum Loss Possible = Greatest Difference In Strike - Net Credit

Iron Butterfly Spread Calculations

From the above example : Assuming QQQQ close at $43 at expiration.

Maximum Profit = $83.00 per position.

Profit % = [($1.65 + $0.85) / ($44 - $43)] x 100 = 250%

Maximum Loss Possible = ($44 - $43) - $0.83 = $0.17 x 100 = $17 per position.

OppiE's Note Notice at this point again that the profit is also higher than a Butterfly Spread by $1.00 with a slightly tighter maximum possible loss. Notice that we are using a $1 strike difference in these examples, giving us a reward/risk ratio of 4.9 : 1. ($83 max profit versus $17 max loss) However, if we should use a greater strike difference in order to better ensure our profitability up to maybe a 40,44,48, our maximum loss will be much higher and our reward risk ratio will be much lower. That is the trade-off we mentioned earlier on.




Risk / Reward of Iron Butterfly Spread:



Upside Maximum Profit: Limited to net credit gained

Maximum Loss: Limited to calculated maximum loss



Break Even Points (Profitable Range) of Iron Butterfly Spread:


An Iron Butterfly Spread is profitable as long as the price of the underlying stock stays within the Profitable Range bounded by the Upper and Lower BreakEven points.

Upper Break Even Point = Short Call Strike + Net Credit

Iron Butterfly Spread Breakeven

Net Credit = $0.83 , Short Call Strike = $43.00

Upper Breakeven Point = $0.83 + $43.00 = $43.83.


Lower Break Even = Short Put Strike - Net Credit

Iron Butterfly Spread Breakeven

Net Credit = $0.83 , Short Put Strike = $43.00

Lower Breakeven Point = $43.00 - $0.83 = $42.17.


In this case, the Iron Butterfly Spread position in our example remains profitable as long as the QQQQ close between $43.83 to $42.17 at option expiration day with maximum profit attained if QQQQ closed at $43.

OppiE's Note Notice that the Profitable Range of an Iron Butterfly Spread ($1.66 range) is also wider than that of a butterfly spread ($1.64 range).




Advantages Of Iron Butterfly Spread:



:: Able to profit on stagnant stocks.

:: Being a credit spread, it reduces overall risk with a higher probability of ending in a profit than a debit spread.

:: Maximum loss and profits are predictable.

:: Very versatile as position can be transformed into a Bear Call Spread or Bull Put Spread easily.



Disadvantages Of Iron Butterfly Spread:



:: Larger commissions involved than simpler strategies with lesser trades.

:: Not a strategy that traders with low trading levels can execute.



Adjustments for Iron Butterfly Spreads Before Expiration :



1. If the underlying asset has gained in price and is expected to continue rising, you could close out all the call options and transform the position into a Bull Put Spread.

2. If the underlying asset has dropped in price and is expected to continue dropping, you could close out all the put options and transform the position into a Bear Call Spread. Such transformations can be automatically performed without monitoring using Contingent Orders.

3. You can use two Iron Butterfly Spreads to form a Double Iron Butterfly Spread.


Recommended!Trade Iron Butterfly Spreads With Best Options Broker, OptionsXpress!




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