Reverse Iron Butterfly Spread

When to Employ the Reverse Iron Butterfly Spread

The reverse iron butterfly spread is designed to be used when you believe that a security is going to move significantly in price, but you are unsure as to which direction it will move in. This strategy will return a profit regardless of which way the price of the security moves, as long the move is big enough.

This is actually one of the least efficient volatile options trading strategies; the potential profits return on investment is lower, and the maximum loss is higher, than both the short butterfly and the short condor. However, those strategies are credit spreads and not every trader has an account that will allow for these.

The reverse iron butterfly spread is a debit spread and is a viable strategy if you are unable to create credit spreads.

How to Create a Reverse Iron Butterfly Spread

There are four legs in the reverse iron butterfly spread, meaning you must place a total of four orders to create it. These orders can be placed simultaneously for simplicity, or if you prefer you can use legging techniques to try and maximize profitability. You have to buy and write both call and put options. The four transactions required are as follows.

• Writing out the money calls
• Buying at the money calls
• Writing out of the money puts
• Buying at the money puts

Each leg should contain the same amount of options, and you should use contracts that share the same expiration date. The two short legs, where you write out of the money options, should use strike prices that are the same distance from the current trading price of the underlying security, but it's down to you to decide exactly how far out of the money you want these options to be.

It's worth bearing in mind that the closer the strikes are to the current trading price of the underlying security the higher their price will be, and you'll receive more for writing them and thus reduce the size of the net debit. However, you'll also be reducing the potential profits too.

Below is an example of how you can apply the reverse iron butterfly spread. To keep the example as simple as possible we have used rounded options prices rather than precise market data. We have also ignored commission costs.

• Company X stock is trading at $50, and you are forecasting a sizable move in either direction.
• You write 1 contract (100 options, $1.50 per option) of out of the money calls (strike $52) for a credit of $150. This is Leg A.
• You buy 1 contract (100 options, $2 per option) of at the money calls (strike $50) at a cost of $200. This is Leg B.
• You write 1 contract (100 options, $1.50 per option) of out of the money puts (strike $48) for a credit of $150. This is Leg C.
• You buy 1 contract (100 options, $2 per option) of at the money puts (strike price $50) at a cost of $200. This is Leg D.
• The total spent on options is $400 while the total credit received is $300. You have created a reverse iron butterfly spread for a total net debit of $100.

Potential for Profit & Loss

The reverse iron butterfly spread needs the price of the underlying security to move a certain amount in either direction in order to make a profit, and the strategy will result in a loss if the price doesn't move enough.

One of the advantages of this strategy is that you can calculate the exact break-even points at the time of establishing the spread. You then know how much you need the price of the underlying security to move by if you are going to make a profit. You can also calculate the maximum profit you can make and the maximum amount you can lose.

We have provided the relevant calculations below, along with some hypothetical scenarios and what the results would be.

• If the price of Company X stock stayed exactly at $50 by the time of expiration, the options written in Legs A and C would expire worthless, as would the ones bought in Legs B and D. With no further returns and no further liabilities, you would lose your initial investment of $100.
• If the price of Company X stock went up to $52 by the expiration date, the calls written in Leg A would be at the money and therefore would expire worthless. The ones bought in Leg B would be worth around $2 each, for a total value of $200. The puts in Legs C and D would be worthless. With $200 worth of options, and taking into account your initial investment of $100, you would make $100 profit.
• If the price of Company X stock went down to $47 by the expiration date, the calls in Legs A and B would be out of the money and worthless. The puts written in Leg C would be worth around $1 each, for a liability of $100. The puts bought in Leg D would be worth around $3 each, for a total value of $300. With $300 worth of options and a liability of $100, and taking into account your initial $100 investment, you would make a total profit of $100.
• Maximum profit is made when “Price of Underlying Stock = or > Strike of Leg A” or “Price of Underlying Stock = or < Strike of Leg C”
• Maximum profit is “(Strike of Leg A – Strike of Leg B) – (Total Net Debit / Number of Options in Leg A”
• There is an Upper Break- Even point and a Lower Break-Even Point
• Upper Break-Even Point = “Strike of Leg B + (Total Net Debit/Number of Options in each leg)”
• Lower Break-Even Point = “Strike of Leg D – (Total Net Debit/Number of Options in each leg)”
• The iron butterfly spread will result in a loss if “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
• The maximum loss will be made if “Price of Underlying Security = Strike of Legs B/D”
• Maximum loss is limited to “Total Net Debit”

Summary

The reverse iron butterfly is a complex strategy, and not just because of the four transactions involved. The commission charges can also be quite high due to the number of transactions. The short butterfly and the short condor are probably preferable, if your broker allows you to create credit spreads. If you can only create debit spreads, then the reverse iron butterfly is a perfectly acceptable alternative.