A reverse iron butterfly is a multi-leg, risk-defined, neutral strategy with limited profit potential. The strategy looks to take advantage of a rise in volatility and large price movement from the underlying asset.
Reverse iron butterflies are essentially a long straddle with short options sold out-of-the-money that reduce the position’s cost basis but limit the profit potential.
Reverse Iron Butterfly market outlook
Reverse iron butterflies are market neutral and have no directional bias but require a large enough move in the underlying asset to exceed the break-even price. A debit is paid when the position is opened, and the risk is limited to the amount paid. Reverse iron butterflies need a significant price change and/or increased volatility before expiration to collect higher premiums when the trade is exited. A sharp rise in implied volatility typically accompanies large moves in stock prices.
An investor would look to initiate a reverse iron butterfly when the belief is the stock price will make a large move in either direction before expiration and implied volatility will increase.
How to set up a Reverse Iron Butterfly
Reverse iron butterflies are similar to long straddles in objective: they depend on large directional moves and increased volatility. However, reverse iron butterflies are less expensive than a long straddle because short options are sold above the long call and below the long put. This lowers the total amount paid to enter the trade, but will limit the profit potential to the width of the spread minus the initial debit paid.
Reverse iron butterflies are typically purchased at-the-money but can be entered above or below the stock’s price to create a bullish or bearish bias. The distance of the spread between the long and short options can be any size. The larger the spread is between the long option and the short option, the greater the maximum profit potential, and the more the strategy will resemble a long straddle. However, less credit will be collected on the short positions to offset the cost of the long positions and the maximum loss will increase.
Reverse Iron Butterfly payoff diagram
The payoff diagram is well defined with a reverse iron butterfly. The maximum loss on the trade is defined at entry by the combined cost of the spread positions. The profit potential is also defined at entry. The width of the spreads minus the combined cost of the spreads is the maximum amount that can be gained.
For example, if a stock is trading at $100, and a reverse iron butterfly with $10 wide wings is purchased at-the-money for $5.00, the max loss is -$500 if the stock closes at $100 on the expiration date. The max profit is $500 if the stock closes above $110 or below $90. The break-even points would be $105 and $95. If the stock price closes beyond the break-even points but within the short strikes, the intrinsic value of the long option, minus the debit paid, is the net profit for the trade.For example, if the stock closes at $107, the profit on the position is $200.
Entering a Reverse Iron Butterfly
Reverse iron butterflies are created by buying a bull call debit spread and a bear put debit spread at the same strike price with the same expiration date. For example, if a stock is trading at $100, a bull call spread could be entered by purchasing a $100 call and selling a $110 call. A bear put spread could be entered by purchasing a $100 put and selling a $90 put. This would create a reverse iron butterfly with $10 wide wings. If the debit paid to enter the trade is $5.00, the max loss would be -$500 and the max profit would be $500 if the stock closed above the short call option or below the short put option.
The spreads can be any width. The larger the width of the spread is between the long option and the short option, the less premium will be paid, but the risk will be higher.
Exiting a Reverse Iron Butterfly
A reverse iron butterfly looks to capitalize on a sharp move in stock price, implied volatility, or both. If the underlying asset moves far enough before expiration, and/or implied volatility expands, the trade is exited by selling-to-close (STC) one or both of the two long spreads. The difference between the cost of buying the premiums and selling the premiums is the net profit or loss on the trade.
Typically, reverse iron butterflies are exited before expiration because an investor will want to sell the options before the extrinsic value disappears. However, if the stock price is above or below the short option at expiration, the maximum profit will be realized. One of the long options will almost certainly be in-the-money at expiration and will need to be exited if the investor does not wish to exercise the option.
Time decay impact on a Reverse Iron Butterfly
Time decay, or theta, works against the reverse iron butterfly strategy. Every day the time value of the long option contracts decreases. Ideally, a large move in the underlying stock price occurs quickly, and an investor can capitalize on the remaining extrinsic time value by selling the option.
Implied volatility impact on a Reverse Iron Butterfly
Reverse iron butterflies benefit from an increase in the value of implied volatility. Higher implied volatility results in higher option premium prices. Ideally, when a reverse iron butterfly is initiated, implied volatility is lower than where it will be at exit or expiration. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the reverse iron butterfly strategy’s pricing.
Adjusting a Reverse Iron Butterfly
Reverse iron butterflies have a finite amount of time to be profitable and have multiple factors working against their success. If the underlying stock does not move far enough, fast enough, and/or volatility decreases, the reverse iron butterfly will lose value rapidly and result in a loss. Reverse iron butterflies can be adjusted like most options strategies but may come at more cost and therefore add risk to the trade and extend the break-even points.
The unchallenged short options may be rolled in the direction of the underlying stock price for additional credit. However, if the stock reverses, the upside potential of the position is limited.
For example, if the underlying stock price moves from $100 to $103, the $90 short put contract may be rolled to a higher strike for additional credit. If the underlying stock has not moved into a profitable zone by expiration, the options can be sold, and a new reverse iron butterfly position can be purchased for a later expiration. This can also be done before expiration if an investor wishes to recapture some of the premium before the contracts expire worthless. Keep in mind that this will require the stock to make an even larger move than the original trade and add risk by increasing the amount of capital committed to the trade.
Rolling a Reverse Iron Butterfly
Reverse iron butterflies can be rolled up or down, or out to a later expiration date, if the stock price or implied volatility has not moved enough to realize a profit. To roll out the reverse iron butterfly, close the current position and initiate a new position for a later expiration. The new reverse iron butterfly may be at the same strike prices or adjusted up or down to reflect any stock price changes.
The downside to rolling out long options is the roll will most likely cost money and therefore increase the debit of the original trade. The risk is still defined, but the additional debit will not only create a higher potential maximum loss, but also require the underlying stock to move more to exceed the break-even point.
Hedging a Reverse Iron Butterfly
Hedging a reverse iron butterfly may be a proactive way to help retain some profits if the stock has moved sharply early in the expiration period, while minimizing the overall risk of the position. Reverse iron butterflies need a sustained move in one direction to realize a profit. However, stocks can move quickly and retrace, leaving a once profitable position worthless.
If the underlying stock moves up or down, an investor may choose to hedge against a future move back in the opposite direction of the initial move. If the underlying asset moves up, an investor may choose to sell a bear call credit spread above the bull call spread. Conversely, if the underlying asset moves down, a bull put credit spread could be sold below the bear put spread. If the underlying stock were to retrace from its initial move, the credit spreads would expire worthless and the credit received would help offset the unrealized profits of the debit spread.
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