An iron butterfly is a multi-leg, risk-defined, neutral strategy with limited profit potential. An iron butterfly consists of selling an at-the-money short straddle and buying out-of-the-money options “on the wings” with the same expiration date to create a risk-defined position.
The strategy looks to take advantage of a drop in volatility, time decay, and little or no movement from the underlying asset.
Iron butterflies are market neutral and have no directional bias. Iron butterflies capitalize on a decrease in volatility and minimal movement from the underlying stock to be profitable. A credit is received when the position is opened. The risk is limited to the spread width minus the premium received. An investor would initiate an iron butterfly when the expectation is the stock price will stay range-bound before expiration and implied volatility will decrease.
Iron butterflies are essentially a short straddle with long option protection purchased above and below the short strikes to limit risk. This creates a bear call credit spread and bull put credit spread centered at the same short strike price with the same expiration date. The combined credit of the spreads defines the maximum profit for the trade. The maximum risk is defined by the spread width minus the credit received.
Iron butterflies are typically sold at-the-money of the underlying asset. However, they can be entered above or below the stock price to create a bullish or bearish bias. The wider the spread width between the short option and long option, the more premium will be collected, but the maximum risk will be higher.
The iron butterfly gets its name from the payoff diagram, which resembles the body and wings of a butterfly. The profit and loss areas are well defined with an iron butterfly. A credit is collected when entering an iron butterfly. The initial credit received is the maximum profit potential. If the underlying price is above or below one of the long strike prices at expiration, the maximum loss will be realized. The break-even points 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.
Any time before expiration, there may be opportunities to exit the position for a profit. This is accomplished by exiting the full position, exiting one spread, or buying back only the short options.
Technically, for an iron butterfly to achieve maximum profit, the underlying stock price would need to close at-the-money of the short options. Because this is unlikely, iron butterflies are typically exited early at a predetermined profit target or days until expiration. For a profit to be realized, the stock price must stay relatively stable and / or implied volatility decreases.
To create an iron butterfly, sell-to-open (STO) a short straddle, buy-to-open (BTO) a call option above the straddle’s strike price, and buy-to-open a put option below the straddle’s strike price. All option contracts have the same expiration date.
For example, if a stock is trading at $100, a call option and put option could be sold at the $100 strike price, with a long call purchased at the $110 strike price and a long put purchased at the $90 strike price. This would create a $10 wide iron butterfly. If the credit received to enter the trade is $5.00, the max profit would be $500 and the max loss would be -$500.
- Buy-to-open: $90 put
- Sell-to-open: $100 put
- Sell-to-open: $100 call
- Buy-to-open: $110 call
Higher volatility will equate to higher options prices. The longer the expiration date is from the trade’s entry, the more the options will cost, and more premium will be collected when the position is opened.
An iron butterfly looks to capitalize on time decay, minimal price movement in a stock, a drop in volatility, or a combination of all three. At expiration, one of the short options will likely be in-the-money and at risk of assignment, so the position needs to be closed if assignment is to be avoided.
Any time before expiration, the position can be exited by closing the entire iron butterfly, one spread, or just the short strikes. If the options are purchased for less money than they were sold, the position will result in a profit.
Time decay, or theta, works to the advantage of the iron butterfly strategy. Every day the time value of an options contract decreases. Ideally, the underlying stock experiences minimal movement, and theta will exponentially lose value as the position approaches expiration. The decline in value may allow the investor to purchase the options contracts for less money than initially sold.
Iron butterflies benefit from a decrease in implied volatility. Lower implied volatility results in lower option premiums. Ideally, when an iron butterfly is initiated, implied volatility is higher than it is at exit or expiration. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the short options.
Iron butterflies can be adjusted to extend the time horizon of the trade or by rolling one of the spreads up or down as the price of the underlying stock moves. If one side of the iron butterfly is in-the-money as the position approaches expiration, an investor has two choices to maximize the probability of success.
The entire position can be closed and reopened for a later expiration date. Adjusting an iron butterfly typically brings in more credit, which increases the maximum profit potential, decreases the maximum risk, and widens the break-even points. Contract size and expiration dates must remain the same to maintain the risk profile.
If one side of the iron butterfly is challenged, the opposing credit spread could be rolled toward the stock price to receive additional credit. The additional credit will widen the break-even points.
However, because iron butterflies are centered at the same short strike prices, this will result in the position being “inverted,” meaning the short call is below the short put or vice versa. When inverted, the distance between the call and put options will be the least amount the position can be repurchased.
For example, if an iron butterfly is centered at $100 with a $10 wide spread (with $110 long call and $90 long put protection), and the underlying stock price rises, the short put could be rolled up to $102. This would create a $2 inversion. If the price closes between $100 and $102 at expiration, the spread could be purchased for $2.00, but never any less. If the credit received from the initial entry plus the credit received from the inversion is wider than the width of the inversion, the position may result in a profit.
- Buy-to-close: $100 put
- Sell-to-open: $102 put
If the $90 long put is not rolled up, the downside risk will increase by $200 per contract because the spread between the short and long put will be wider.
Iron butterflies can be rolled out into the future, and / or the strike prices can be rolled up or down to maximize the potential profit on the trade. The passing of time works in favor of an options seller. If expiration is approaching and the position is not profitable, the original iron butterfly position may be purchased and resold for a future expiration date. This may result in a credit and will extend the trade's time duration and widen the break-even points.
For example, if the original iron butterfly is centered at $100 with a June expiration date and received $5.00 of premium, the investor could buy-to-close (BTC) the entire position and sell-to-open (STO) a new position in July. If this results in a credit of $1.00, the maximum profit potential increases and the maximum loss decreases by $100 per contract. The new break-even points will be $94 and $106.
The most efficient way to hedge an iron butterfly is to roll the unchallenged spread in the direction of price movement.
For example, if the price of the underlying stock has moved higher and is challenging the bear call credit spread, the original bull put credit spread could be closed and reopened closer to the current stock price. This will increase the amount of credit received, and if the price of the stock continues higher, the bull put spread will remain profitable, while the bear call spread will lose money. However, if the stock price reverts, there is risk of dual assignment if the underlying settles between the short call and short put option.