Reverse Iron Butterfly Spread

How Does Reverse Iron Butterfly Spread Work in Options Trading?

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Reverse Iron Butterfly Spread - Introduction

The Reverse Iron Butterfly Spread is a complex, advanced volatile option trading strategy built upon the foundation of a Short Butterfly Spread.

In fact, the Reverse Iron Butterfly Spread is the debit spread version of the Short Butterfly Spread (which is a credit spread). As the name suggests, the Reverse Iron Butterfly Spread is where you buy an Iron Butterfly Spread from someone who is betting on the underlying stock staying stagnant. This allows you to profit when the underlying stock moves either up or down quickly.

Learning the Iron Butterfly Spread first makes the Reverse Iron Butterfly Spread easier to understand.

Find Options Strategies With Similar Risk Profiles

Unlike the Short Butterfly Spread and the Short Condor Spread, the Reverse Iron Butterfly Spread is a debit spread. This means that it is a strategy which you can execute even if your trading account does not allow you to execute credit spreads.

Comparing The Reverse Iron Butterfly Spread

The Reverse Iron Butterfly Spread belongs to the family of complex volatile option strategies, similar to the Short Condor Spread, Short Butterfly Spread and Reverse Iron Condor Spread. Each of them has their own strengths and weaknesses but they all have one thing in common, and that is, they all have narrower breakeven points than the basic Straddle / Strangle and a lower maximum loss than a Straddle even though their maximum profit potential is limited. Here is a table explaining the differences:

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

As you can see from the table above, all of the above complex volatile 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. The Reverse Iron Butterfly Spread, as a debit spread, has a lower profitability and higher maximum loss than the Short Condor Spread or Short Butterfly Spread, which are credit spreads. Therefore, the Reverse Iron Butterfly Spread is a complex volatile strategy that you should perform only if your broker does not allow you to execute credit spreads.

When To Use Reverse Iron Butterfly Spread?

One should use a Reverse Iron Butterfly Spread when one expects the price of the underlying asset to make a quick break to either upside or downside and is unable to execute credit spreads. One can use this strategy ahead of earnings releases or important releases.

How To Use Reverse Iron Butterfly Spread?

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

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

Example : Assuming QQQQ trading at $43.57. Sell To Open 1 contract of Jan $44 Call at $1.06 Buy To Open 1 contract of Jan $43 Call at $1.63. Sell To Open 1 contract of Jan $42 Put at $0.59 Buy To Open 1 contract of Jan $43 Put at $0.85. Net Debit = (($1.63 - $1.06) + ($0.85 - $0.59)) x 100 = $83.00 per position

Contrast this example with the example in Short Butterfly Spread. These examples are made using the same QQQQ on the same strike price and real values. You will see that instead of getting $25 per position to put on the Short Butterfly Spread, you actually pay $90 per position for putting on the Reverse Iron Butterfly Spread.

Trading Level Required For Reverse Iron Butterfly Spread

A Level 3 options trading account that allows the execution of debits spreads is needed for the Reverse Iron Butterfly Spread. Read more about Options Account Trading Levels.

Profit Potential of Reverse Iron Butterfly Spread :

Reverse Iron Butterfly Spreads achieve their maximum profit potential at expiration if the price of the underlying asset exceeds the upper or lower breakeven point. The profitability of a reverse iron butterfly spread can also be enhanced or better guaranteed by legging into the position properly.

Profit Calculation of Reverse Iron Butterfly Spread:

Maximum Profit = Greatest Difference In Strike - Debit
Maximum Loss Possible = Net Debit

From the above example : Assuming QQQQ close above the upper breakeven point or lower breakeven point. Maximum Profit Possible = ($44 - $43) - $0.83 = $0.17 x 100 = $17 per position. Maximum Loss = $83.00 per position.

Notice at this point again that the percentage profit is also much lower than a Short Butterfly Spread with a much higher maximum possible loss.

Risk / Reward of Reverse Iron Butterfly Spread:

Upside Maximum Profit: Limited

Maximum Loss: Limited to net debit paid

Break Even Points of Reverse Iron Butterfly Spread:

An Reverse Iron Butterfly Spread is profitable as long as the price of the underlying stock exceeds the price range bounded by the Upper and Lower BreakEven points.

Upper Break Even Point = Long Call Strike + Debit

Net Debit = $0.83 , Long Call Strike = $43.00 Upper Breakeven Point = $0.83 + $43.00 = $43.83.

Lower Break Even = Long Put Strike - Debit

Net Debit = $0.83 , Long Put Strike = $43.00 Lower Breakeven Point = $43.00 - $0.83 = $42.17.

In this case, the Reverse Iron Butterfly Spread position in our example is profitable as long as the QQQQ close outside a range of $43.83 to $42.17 on option expiration day. Notice that this range is much narrower than in the Straddle or Strangle.

Advantages Of Reverse Iron Butterfly Spread:

:: Typically has a narrower breakeven range than a straddle or strangle.

:: Maximum loss and profits are predictable.

:: Able to profit whether the stock moves up or down.

:: Can be used by option traders who cannot use credit spreads.

Disadvantages Of Reverse Iron Butterfly Spread:

:: Lower profit and higher loss than the Short Butterfly Spread or the Short Condor Spread.

:: Potential loss is much higher than the potential gain.

Adjustments for Reverse 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 put options and transform the position into a Bull Call Spread.

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

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