This episode talks about the iron butterfly strategy and shares eight tips to get you ready for your next trade. This is a popular and potentially powerful strategy any trader can add to their portfolio, regardless of their experience level.
Before diving into the eight tips (plus one bonus suggestion!), we break down the basics to help you understand how iron butterflies work. Although iron butterflies are not complicated, we want first to answer some important questions to give you the confidence needed to trade the strategy.
What is an Iron Butterfly?
An iron butterfly is a multi-leg, risk-defined neutral strategy.
Iron butterflies look to take advantage of time decay, decreasing volatility, and limited movement from the underlying asset.
To set up an iron butterfly, you combine two opposing spreads: a put credit spread and a call credit spread.
You can also think of an iron butterfly as the marriage of two separate neutral trades: a short straddle and a long strangle.
For example, to enter an iron butterfly at $100, you sell a call option and put option with a $100 strike price. You purchase a long call option above the short call option and a long put option below the short put option to create the butterfly's “wings.”
An iron butterfly that collects $5.00 and has $10 wide wings has a max loss of -$500. The max profit potential is $500 (the credit received).
It is important to understand the impact time decay and implied volatility have on an iron butterfly.
Theta benefits iron butterflies. Every passing day reduces the options’ value, which is good for option sellers.
Implied volatility also has a significant impact on the strategy. Iron butterflies look to capitalize on a decrease in implied volatility. Conversely, if volatility rises, option premiums go up across the board.
To exit an iron butterfly, you’ll use closing orders to buy the position for a debit. The goal is to exit an iron butterfly for less than the credit received to enter the position. The difference between what you sold the iron butterfly for and what you bought it for will be your profit or loss.
You can also close iron butterfly positions by legging out of one spread.
For example, if the stock is rallying higher, you could close out of your put spread and leave the call spread position in place.
It’s okay if the stock moves within a defined range before expiration, but if the underlying price exceeds a break-even price, an iron butterfly will not be profitable at expiration and you should consider adjusting, rolling, or hedging the position.
Adjustments can and should be used to reduce risk in your portfolio. Rolling is also a powerful technique for iron butterflies when you can take in a net credit.
8 Iron Butterfly Tips
1. Wider vs. Taller
- The iron butterfly payoff diagram has a tall peak in the center and that's your maximum profit point. The maximum profit occurs if the position expires at-the-money of the short option’s strike prices.
- Buying wings further out on the position creates a very wide pyramid-shaped payoff diagram that allows the stock to move in a much wider range. Buying wider wings increases the credit received because options further out-of-the-money are less expensive. More credit equals wider break-even points and higher profit potential, but the max risk increases.
2. Focus on High Implied Volatility Levels
- Implied volatility tends to overstate a security’s expected move, giving option sellers an edge.
- Even in low implied volatility conditions, iron butterflies are still generally profitable.
- It’s always a good idea to scale back your position size during lower implied volatility levels, and start to get more aggressive, or scale up your position size, when implied volatility increases.
3. Default to Fewer Contracts
- More contracts mean more associated risk.
- Fewer contracts are easier to manage, cheaper, and less stressful.
- Learn to trade with less risk; it is always easier to increase size when you are confident in you strategy.
4. Know Your Break-Even Prices
- The break-even prices are determined by the total credit received, above or below the short options.
- For example, if an iron butterfly is opened for a $5.00 credit, the break-even price will be $5.00 above and below the short strikes.
- With autotrading, you can use bots to build iron butterfly strategies that have a high probability of success, and it will automatically account for the breakeven prices.
- You can also use a decision recipe to estimate the probability of maximum loss.
5. Probability Paradox
- When you initially enter iron butterfly positions, they don't always look like they have the highest probability of success.
- The expected probability paradox shows that the actual likelihood of success on iron butterflies is much higher than the initial probabilities suggest.
6. Pre-Plan Inversions
- Start to think about how you would adjust positions before you need to adjust.
- Take the time before entering a trade to focus on what you would do if you're challenged.
7. Have Multiple Automated Exits Points
- This is where you can use bots to your advantage.
- If you are a manual trader, you will have to watch, monitor, and calculate this all the time.
8. Consider Different Durations
- Use Option Alpha’s backtester to test different durations for iron butterflies.
- If you start trading with bots and automation, you don't have to monitor positions as closely because you know the bots are there to manage your positions.
9. BONUS - Automate Everything!
- When you start trading with automation and start letting automated tools take over your trading, you can make more systematic and less emotional decisions.
- You can trust the data and let bots manage your positions because you know the probabilities are in your favor.
Check out this awesome template shared in the Community to help get you started trading iron butterflies inside the platform.
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Don't miss this Iron Butterfly workshop.
Here are the backtest inputs and results discussed in the podcast:
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