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Understanding Iron Butterfly Options Trading Strategy

09 Sep 2023

Introduction:

Trading in options can be risky. It’s because it comes with an expiry date and involves a significant sum of money. But if you can do it diligently, you can make large profits in short durations. Thankfully, there are several options trading strategies that you can utilise to earn money in varying market conditions.

This article discusses one such strategy in detail – the Iron Butterfly strategy. It is a limited-risk strategy that works best when there is little to no movement in the value of the underlying securities. Keep reading to know more.

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What is the iron butterfly strategy?

The iron butterfly strategy, also known as the iron fly strategy, is an options trading strategy that involves a combination of multiple calls and put options. It is a defined-risk strategy with a directionally neutral approach towards the market. This strategy helps generate profit when the price of the underlying securities remains range-bound as the option’s expiry date approaches.

If you’re familiar with the iron condor strategy, the iron butterfly strategy will seem similar. Like the iron condor, the iron butterfly involves four call-and-pull options with the same expiry date and different strike prices. To create an iron butterfly, you must run a short call spread and a short put spread simultaneously, with both spreads converging at a middle strike price.

How to create an iron butterfly?

As mentioned, the iron butterfly strategy involves two call options and two put options with a short call spread and a short put spread running simultaneously. You need to take four options trading positions with three strike prices – upper, middle, and lower. Below are the steps to create an iron condor:

Step 1 – Buy a slightly out-of-the-money Put Option with a strike price ‘A’

Step 2 – Sell an at-the-money Put Option with a strike price ‘B’

Step 3 – Buy a slightly out-of-the-money Call Option with a strike price ‘C’

Step 4 – Sell a Call Option with the same strike price as ‘B’

Here, all three strike prices – A, B, and C – must be equidistant from each other, and all options must have the same underlying security and the same expiry date. Like the iron condor, the iron butterfly is also a four-legged options trading strategy with a bull call spread and a bear put spread.

The Iron Butterfly Strategy: An illustration

Now, let’s understand how the iron butterfly strategy works with the help of an illustration. Suppose the shares of a company ABC are trading for Rs. 100. You feel these shares will remain range-bound in the upcoming month, so decide to use the iron butterfly strategy.

- You buy a Put Option with a strike price of Rs. 90 and at a premium of Rs. 10

- You sell a Put Option with a strike price of Rs. 100 and for a premium of Rs. 20

- You buy a Call Option with a strike price of Rs. 110 and at a premium of Rs. 10

- You sell a Call Option with a strike price of Rs. 100 and for a premium of Rs. 20

Imagining each option to have a lot size of 1,000 shares, your initial gain at the outset would be Rs. [(20 x 1000 + 20 x 1000) – (10 x 1000 + 10 x 1000)], i.e., Rs. 20,000. It means you start with a net profit.

Now, if the share price shows little or no fluctuation and closes at the middle strike price, i.e., Rs. 100, all four options will expire worthless as none of the buyers would want to exercise their right to buy/sell shares. And in such a case, you can keep your initial profit of Rs. 20,000.

However, you may incur a loss if the share price closes below or above the middle strike price. It’s because any call or put buyer may want to exercise his right. The greater the market volatility, the larger your quantum of loss.

The Bottom Line

The iron butterfly strategy helps you gain from sideways or less volatile markets. You can execute this strategy with limited capital, and your maximum loss or profit would be defined. However, this technique's sweet spot for gains is very narrow, requiring much experience for proper execution. So, if you’re a beginner, it’s advisable to take your time and acquire some expertise before attempting such a complex strategy.

If you want to start your stock investment journey, you can open a Motilal Oswal Demat account for free.

 

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