Iron Butterfly Spread

When to Apply an Iron Butterfly Spread

As a neutral strategy, the iron butterfly is designed to return a profit when the underlying security doesn't move much in price. It's a flexible strategy that you can adjust to increase the probability of returning a profit if you are prepared to risk higher potential losses. It can offer a high return if the price of the underlying security doesn't move at all, so it's a good strategy to use if you are very confident that there will be little to no volatility.

How to Apply an Iron Butterfly Spread

The iron butterfly spread consists of four legs, which means there are four orders you must place with your broker when creating it. You will need to use the buy to open order and the sell to open order, because you need to buy options and write options. The four transactions that are required are as follows:

• Buy out the money calls
• Sell at the money calls
• Buy out of the money puts
• Sell at the money puts

The number of options in each leg should be equal, and they should all use the same expiration date. The strikes of the out of the money puts and the out of the money calls should be equidistant from the current trading price of the underlying security.

You must decide how far out of the money you wish these options to be. Using far out of the money contracts will increase the likelihood of making a profit, because the profitable range will be wider. However, this will also increase the maximum losses if the underlying security should move outside the profitable range.

We have provided an example of the iron butterfly spread below to illustrate how it can be applied. We haven't used real market data, but instead used hypothetical options prices to keep things simple. We have also ignored commission costs.

• Company X stock is trading at $50, and your expectation is that the price will stay at around that price.
• You buy 1 contract (100 options, $1.50 each) of out of the money calls (strike $52) at a cost of $150. This is Leg A.
• You write 1 contract (100 options, $2 each) of at the money calls (strike $50) for a credit of $200. This is Leg B.
• You buy 1 contract (100 options, $1.50 each) of out of the money puts (strike $48) at a cost of $150. This is Leg C.
• You write 1 contract (100 options, $2 each) of at the money puts (strike $50) for a credit of $200. This is Leg D.
• The total credit received is $400 and the total cost is $300. You have created an iron butterfly spread for a net credit of $100.

Potential for Profit & Loss

For the iron butterfly spread to return the maximum possible profit, the underlying security must remain at $50 by the time of expiration. This will result in the options in all legs expiring worthless, so you will basically just keep the net credit ($100 in this example) as your profit.

There's still profit to be made if the underlying security does move a little, and there are upper break-even points and lower break-even points. If the price of the underlying security goes above the upper break-even point or below the lower break-even point, then the strategy will return a loss.

The maximum loss will be made if the price of the underlying security goes above the strike of the long call (Leg A) or below the strike of the long put (Leg C). There are formulas for calculating the maximum loss, the maximum profit, and the break-even points. We have summarized these below, along with providing details of what would happen to our example iron butterfly spread in various outcomes.

• If the price of Company X stock stayed exactly at $50 by the time of expiration, the options bought in Legs A and C would remain out of the money and expire worthless. The ones written in Legs B and D would remain at the money and also expire worthless. Your profit would be the net credit.
• If the price of Company X stock went up to $52 by the time of expiration, the options bought in Leg A would be at the money and worthless. The ones written in Leg B would be worth around $2 each, for a total liability of $200. The ones in Legs C and D would be out of the money and worthless. Your total liability of $200 would be partially offset by the $100 net credit, and your total loss would be $100.
• If the price of Company X stock went down to $48 by the time of expiration, the options in Legs A and B would be out of the money and worthless. The ones bought in Leg C would be at the money and worthless. The ones written in Leg D would be worth around $2 each, for a total liability of $200. Your total liability of $200 would be partially offset by the $100 net credit, and your total loss would be $100.
• Maximum profit is made when “Price of Underlying Stock = Strike in Legs B/D”
• Maximum profit is the net credit received
• The iron butterfly spread has two break-even points (Upper Break- Even point and Lower Break-Even Point)
• Upper Break-Even Point = “Strike Price of Legs B/D - (Net Credit/Number of Options in each leg)”
• Lower Break-Even Point = “Strike Price of Legs B/D + (Net Debit/Number of Options in each leg)”
• The iron butterfly spread will return a profit if “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
• The iron butterfly spread will result in a loss if “Price of Underlying Security > Upper Break-Even Point or < Lower Break-Even Point”
• The maximum loss will be made if “Price of Underlying Security = or > Strike of Leg A” or “Price of Underlying Security = or < Strike of Leg C”.

Summary

The iron butterfly is clearly a complex trading strategy, primarily because of the number of transactions involved. The number of transactions also means you will pay higher commissions than you would if using some of the simpler strategies. However, you can calculate the maximum potential profit and the maximum potential loss at the time of applying the strategy, which is a useful benefit.

Overall, the iron butterfly spread is a good strategy to use if you are making a sizable trade (so the commission charges won’t matter so much), and you are confident that the underlying security won't move much, if at all, in price.