The iron butterfly options strategy, sometimes also known as the iron fly options strategy, is one of the best and most popular options trading strategies. This strategy has gained so much attention because it offers finite loss potential. That said, the peace of mind this superb strategy brings makes it a darling for options traders.
Are you also an options trader and looking to capitalize on the iron butterfly options strategy to limit your risk? And you want to know all about how to trade it? Then you needn’t look anywhere else. Because today’s post is all that you need to know what iron butterfly options strategy is and how to trade it. Let’s dive deep and find out!
Iron butterfly options strategy definition
The iron butterfly options strategy is an options trading strategy that involves four options contracts to earn a limited profit while limiting risks if prices fluctuate within a specified range.
So, this is a limited risk strategy that limits risks as well as suppresses profit potential. In fact, it offers much-needed protection to traders’ investments. The iron butterfly strategy is highly suitable for less volatile markets and traders use it when the forecast limits price movements of the underlying financial asset until the expiry of options contracts. When correctly traded in a less volatile market, it serves traders in two ways. Firstly, it enables them to maximize profits. Secondly, it empowers them to incur significant losses because it hedges against the risk of adverse price movements.
To sum up, the iron butterfly options strategy is an options strategy that gives a better risk to reward ratio. It is a balancing strategy that limits both profit and risk. Moreover, this strategy is suitable for lower volatility and for seasoned traders who know how to efficiently balance all the elements involved.
How to trade iron butterfly options strategy?
1. The basics of options trading
Before understanding how to trade the iron butterfly options strategy, let’s discuss the basics first. Firstly, how do options traders make a profit? They make a profit from the fluctuations in stock prices.
Secondly, what are the call options and put options contracts? Call options contracts give holders the right to buy the underlying security at the strike price against the premium paid. When the asset’s price rises above the strike price, the call options buyer makes a profit at the expense of the loss incurred by the seller. Whereas, a put options contract gives the holder the right to sell until expiry. The holder buys a put options contract at the strike price by paying a premium. When the price of the underlying security falls below the strike price, the buyer sells and makes a profit while the buyer incurs a loss.
2. Trading iron butterfly options strategy
Now, let’s discuss how to trade iron butterfly options. What are the basics of this strategy and how does it work? There is a simple principle – use both buy and put options contracts to make a profit while limiting risks. This is exactly what professional and experienced options traders do. They often use both call and put options to ensure profit while keeping risk to a minimum level. And this is exactly what you do when executing the iron fly options strategy.
As the definition states, an iron butterfly involves four options contracts. These four options contracts must be of the same expiry date and include a bear call spread, a bull put spread, a short call, a short put. Moreover, this strategy involves trading all four options contracts at three strike prices – lower, middle, and higher.
How do you do it?
When it comes to execution, you can trade the iron butterfly options strategy by using the following steps.
- Step 1 – Step 1 involves analysis. The analysis is important to correctly predict that the price of the targeted asset will remain in a limited range. Remember that the success of the iron fly strategy totally depends on the correct prediction of price action.
- Step 2 – Step 2 involves selling one call option and one put option at the same target price and that is the middle strike price. Selling these two options makes the body of the butterfly.
- Step 3 – Step 3 involves buying one call option and one put option. Here the target price is different. You need to buy the call put option above the target price while buying the put option below it.
So, the iron butterfly options strategy is executed in just three steps. However, it is important to look at the volatility because low volatility suits this strategy. After completing those steps, you just need to wait and enjoy the show. You will make a maximum profit if the price closes at or near the strike price. Conversely, you will make maximum losses if the price moves beyond your predicted price range. That’s why we reiterate the importance of correct price speculation.
The possible outcomes of the iron butterfly options strategy
There are three possible outcomes of every strategy – profit, loss, or breakeven. The same criterion applies to the iron fly options strategy.
1. Profit scenarios
As we mentioned earlier, options traders using this strategy make maximum profit when the price of the underlying security closes at the strike price level. In other words, the price of the underlying asset at expiry is equal to the strike price at which you sell call and put options. Furthermore, the difference between the closing price at the expiry and the strike price determines your profit. Profit decreases as the difference between these two price levels increases. If we put it all into an equation, it will look like this;
Limited profit = (Put option sold + Call option sold) – (Put option bought + Call option bought)
2. Loss scenarios
As we already have mentioned this too, you will make maximum losses if the price moves beyond your predicted price range. However, maximum losses are limited when using the iron butterfly options strategy. This is the beauty of this strategy and that is why it is popular. In simple terms, you incur a maximum loss in two cases. The first one is when the price of the underlying security falls at or below the lower put bought. The second one is when the price of the underlying asset rises at or above the higher strike price level. Again, the equation is;
Limited loss = Spread – Net credit
3. Breakeven scenarios
There are also two scenarios that bring breakeven. The first one is the upper breakeven point – when the total of the net premium received and a strike price of call sold are equal to the upper breakeven point. Whereas, the second one is the lower breakeven point – when the difference between the strike price of the short put and the net premium received is equal to the lower breakeven point.
Let’s try to understand the iron butterfly options strategy through a couple of examples. Firstly, let’s imagine a company XYZ and its stock is trading at $40 in March 2022. Now, a trader wants to execute an iron fly options strategy after speculating on XYZ’s stock price. He speculates that the stock price will remain within a particular range.
What does the trader have to do now? He needs to sell a put option and a call option at the middle strike price which is $40. The Premium he has to pay on both options is $3 and $2 respectively. The strategy also requires the trader to buy two more options contracts – one above and one below the strike price. Suppose he buys a call option at the higher strike price of $45 and pays a premium of $1.20. He also has to buy a put option at the lower strike price of $35 by paying a premium of $1.00. So, these two option contracts make a shield to prevent unlimited losses.
So, what will be the possible outcomes here?
Limited profit = $3 + $2 – $1.20 – $1.00 = $2.80
As, the spread is $5, therefore;
Limited loss = $5 – $2.80 = $2.20
Whereas, the trader can achieve breakeven levels in the following two scenarios;
Strike price + Net credit = $40 + $2.80 = $42.80
Strike price – Net credit = $40 – $2.80 = $37.20
So, the trader will have to bear significant losses if the price goes beyond breakeven points. Conversely, if the price remains within the predicted range, the trader will make profits. The profit will be maximum if the price remains at the strike price level at the expiry.
The iron butterfly options strategy is a very useful strategy for options trading. It involves the use of four options contracts that suppresses profit but also limits risk. However, it is important to use this strategy in low volatility markets. Moreover, the success of this strategy depends on making the correct price prediction.
The execution of the iron fly options strategy isn’t as complex as it seems. There are three steps. The first one is price speculation. The second one is selling one call option and one put option at the same target price and that is the middle strike price. Finally, the last step is about buying one call option and one put option. Here the target price is different. You need to buy the call put option above the target price while buying the put option below it. After completing these steps, you are required to wait and watch.
If the price of the underlying asset remains within the speculated range, you will make a profit. However, if the price breaks out of the range, you’ll have to bear losses. That said, trading is a risky game. Although it offers huge potential for making profits, it also accompanies huge losses. Therefore, try your best to learn everything about trading and gain experience before risking too much money.