In today's video, I want to go through the specifics of how you would build and trade an iron butterfly. This is one of our favorite strategies to use when implied volatility is high.
It’s a very cool video, and hopefully, you guys enjoy this. You could think of an iron butterfly as a combination of a short straddle and an iron condor. It gets its iron butterfly name because it looks like a butterfly spread, but it's not created using the same butterfly option strikes that you would typically find.
It’s a great strategy to use during very high implied volatility setups when you want also to reduce the capital required to hold the trade, and we’re going to show you how it reduces the capital required to hold the trade here in a little bit. How do you setup this strategy?
First thing you’re going to do is you’re going to sell an at the money call, then you’re going to buy an out of the money call at some higher strike price and you’re also going to go across the option chain and sell an at the money put option at the same strike price as the call option that you sold.
The first option that you sold, that call option, we’re going to sell the same strike price with the put option, and on the put side, we’re going to go out of the money even lower in buying option for protection.
The wider that you make the difference between the at the money strikes and the out of the money strikes will increase your credit on the trade, but it will also increase a little bit your risk in the position. What’s the risk in this trade?
Your risk is limited to the width of the strikes that you entered on either side. We usually do these about $5 or $10 wide less the credit that you received. In this case, if you have a $5 wide strike and you took in a $1 credit, your maximum risk would be $4.
Profit potential on these trades should the stock remain neutral trading at the short strikes; you could make at most the net credit received from entering the trade. That’s the ideal situation, the peak at which this profit loss diagram is right on the left side of the screen here.
In most cases, what we’re going to try to do is to close out this trade a little bit early and take a profit. That's not exactly a full profit, but as soon as the stock sees a drop in implied volatility, we should get a nice little profit that starts to materialize.
An increase in implied volatility does have a negative impact on this position because we said that we want to enter these trades when implied volatility is very high.
Because we’re short two credit spreads on either side of the market, we want to see a drop in implied volatility, so let’s put us in a good position by first entering these trades when IV is high.
Time decay is going to help these positions since we're net premium sellers on both sides of the market. The closer we get to expiration, the faster a profit will start to materialize.
Breakeven points are very easy to calculate in this type of a trade. What we’re going to do is we’re going to take the short at the money strikes, whichever strike prices we sold on both sides, and we’re going to add or subtract the net credit received depending on which side you're going to. It’s got two breakeven points.
If you’re going to calculate the lower breakeven point, you take the at the money short strike, and you subtract the net credit. To calculate the higher breakeven point, you take the at the money short strike and add the net credit that you have received.
Let’s go to our broker platform here on Thinkorswim, and we’re going to build a trade that we’re going to try to place right now. I’m not sure if it’s going to get filled. But right now, gold is trading much, much higher.
You can see it’s had a huge, huge run-up. Not only that, but implied volatility remains very high with gold, so it's up in the 71st percentile. That means over the course of the last year, about 71%, 72% of the time, implied volatility is usually lower than it is right now.
What we’re going to do is build an iron butterfly around this trade because we think that either gold is going to stop increasing at the same rate, meaning it’s not going to continue to move up at the same pace or implied volatility is going to drop at some point which is going to help our options that we’re selling.
We’re going to go here to the analyze tab, and we’re going to type in GLD real quick, and we’re going to make sure that we’re trading out far enough here. We’re going to go to the March options which have about 57 days to go.
You can see what we're going to do is try to target our short strikes somewhere close to where GLD is trading right now. You can see GLD is trading about 125.41 or so and we might start just to skew this a little bit and go up to the 126 strikes.
You can see the market is rallying here as we’ve got live trading on. It’s up at 125.5, so we’re going to skew it just a little bit higher and do the 126 options as our mid-price. The first thing that we’re going to do is sell a call spread above the market using that short strike.
We just go in here to vertical call spread. We’re going to sell the 126 call, and we’re going to buy the 127. This is how it defaults, but we want to move a couple of strikes out of the money.
We’re going to move five strikes out and go to the 131 calls, and that’s going to give us a little bit more credit in this trade. We’re also going to do the same strikes as far as our short strikes on the bottom side.
We’re going to do the 126, and we’re going to sell a vertical in that case. The 126 then defaults to buying the 125, but we want to go about five strikes out and go down to the 121s. You can see we’re targeting the 126 options right in the middle.
On the topside with the calls, we’re going to buy the 131s and on the bottom side with the puts, we’re going to buy the 121s. It’s still very balanced, it's five strikes apart on either end, but it’s all targeted around 126 as far as a price.
The net credit that we receive in this case is about $390, and since the width of our strikes is $5, that leaves about $110 of risk, so a very high risk to reward ratio in this trade.
When we go here and look at the profit loss diagram, you can see it looks very similar to a butterfly spread because it’s got this high peak and it’s got even sides on each side of the strategy, but remember, it’s two credit spreads that you're putting together.
In this case, because of implied volatility being so high, we can make money between about 122 and about 130 on this trade. It gives us a very wide window of opportunity to make money.
When we go to the chart here, about 122 is right in this range, and about 130 is right in this range for GLD. This is our profit window, and it leaves just a little bit more room for GLD to move higher, but then fall into a range or sit sideways as we head into expiration.
That’s exactly how we would build that strategy, and we’re going to go ahead and place this order right now, and you can see that it’ll go through. As soon as we hit confirm and send here, this order will go through.
This is one of the beautiful parts about trading this type of strategy, is that the buying power effect is just limited to your potential loss plus the trading commissions.
In our case, the buying power of doing this strategy is just $115, so it’s a very easy way for somebody who's got a smaller account to make a trade in this type of position and potentially get a very nice reward for minimal risk, but you got to pick and choose your entries here.
We’re going to go ahead and enter that trade. It might get filled; it might not. One of the things that we’re going to look at is this is compared to doing a straddle which is at the money. Let’s look at just what a straddle price would be in this case.
A straddle would be just the at the money strikes of the 126 call and put. You see that we take in a higher credit here on the straddle. It's about $782. There’s no doubt we take in a higher credit.
But if we hit confirm and send here, you can see that the margin required to hold this position is about $2,500. As far as margin is concerned, it’s a very capital-intensive strategy and it only works best if you have a much larger account size.
Straddles and strangles, we don't suggest for people who are trading smaller account sizes. We suggest you can do the iron butterfly because it's just a great use of capital and still gives a great risk reward ratio.
Takeaways for this strategy: This should only be used during very high implied volatility setups. We’ve said it again and again, but it’s so important to say that just another time because that's where you get the benefit and the edge in the market.
You’ll want to maximize your credit by spreading your strikes wide if you can. Again, we do $5 to about $10 wide. An iron butterfly is also a great alternative to a short straddle as we just showed you because if you want to reduce your capital requirement on a particular trade, this helps you do that.
You do reduce your overall dollar amount that you'll receive on the trade, but it also reduces dramatically the capital that you have to invest in your overall risk in the trade.
We like this type of a strategy during high implied volatility setups like we just got in GLD. As always, I hope you guys enjoy this video. If you have any comments or questions, please add them right below. Until next time, happy trading!