An iron butterfly spread is an advanced options strategy that consists of three legs and four total options. The trade involves joining a bull put spread and a bear call spread at strike price B. Another way to look at an iron butterfly is to see it as an iron condor, just with the short strikes, both calls and puts, as being at the same strike price verse spread wide. The trade is established for a total net credit as the investor is short both the put and the call spread.
A trader who opens this trade is betting that the stock will pin or come close to pinning at strike price B. If the stock does pin at the short strikes then all the options would expire worthless and the investor would keep the entire premium received.
This trade is generally a natural direction strategy but can be slightly bullish or bearish, depending on where the stock is in relation to the short strikes when opened. It is bullish if the stock is lower than strike price B and bearish if the stock is higher than strike price B.
The maximum profit would be the premium received for the trade, so if a trader received a $3.40 credit for opening the trade, the maximum profit would be $3.40.
The maximum loss is calculated by taking the difference between the lower strike price and the middle strike price, then subtracting the credit of the trade. For example, if the distance between point A and B was $5 and the premium received was $3.40, then the max loss would be $1.60.
There are two breakeven points. The upper breakeven point would be calculated by taking the short strike price (point B) and adding the premium received for the trade. So, if point B was a 100-strike price option, and the credit received was $3.40, the upper breakeven would be $103.40.
The lower breakeven point would be calculated by taking the short strike price (point B) and subtracting the premium received for the trade. So, if point B was a 100-strike price option, and the credit received was $3.40, the lower breakeven would be $96.60.
If XYZ is trading $100 and is expected to trade sideways over the next 45 days, a trader could execute a 95/100/105 iron butterfly spread by buying one 95-strike price put, selling one 100-strike price put, selling one 100-strike price call, and buying one 105-strike price call for the following prices:
- Buy 1 XYZ 95-strike price put for $0.50
- Sell 1 XYZ 100-strike price put for $2.20
- Sell 1 XYZ 100-strike price call for $2.20
- Buy 1 XYZ 105-strike price call for $0.50
- Total premium = $3.40 credit
If the stock pins at $100 at expiration, the investor will keep the $3.40 credit, and all positions would expire worthless and be removed from the account.
If the stock trades down to $95 at expiration, then the trader will lose $5 on the short 100 put, while all other options expire worthless. Because the trader received a credit of $3.40, their net loss would be $1.60.
If the stock traded up to $102, the investor would lose $2 on the 100-strike call, and all other options would expire worthless. Because the trader received a credit of $3.40, their net profit would be $1.40.
This type of spread is sensitive to changes in implied volatility. The net price of the spread increases when implied volatility rises, and the price decreases when implied volatility falls. The trader who executes this trade wants implied volatility to drop, so they can then buy the trade back for cheaper.
This trade is often performed right before earnings, when implied volatility is high, once the earning report comes out and implied volatility drops, the value of the spread drops allowing the investor to repurchase it cheaper. However, if there is a significant disparity in earnings, a hefty price swing can take this trade to a loser pretty quickly.
The iron butterfly spread is not a strategy for a beginner, it’s recommended for experienced options traders.