What is the Iron Butterfly Option Strategy?

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  • 04 Oct 2023

The Butterfly strategy, often referred to as a risk options strategy that's not directional and is aimed at encouraging investors to make good profits, is the Risk Option Strategy. This can happen if the underlying asset's future volatility is higher or lower than its current volatility.

Options have a wide range of strategies to make money that cannot be replicated with conventional securities, and not all are risky. In particular, an iron butterfly strategy can create stable income while limiting risk and profit.

The iron butterfly strategy belongs to a series of options known as wingspread, named after flying creatures such as butterflies or condors. The strategy combines a bear call spread with a bull put spread that overlaps the middle strike price, creating an identical expiration date. A short call and put are offered for sale at the middle strike price, forming the "body" of the butterfly. Accordingly, a call and put are bought either above or below the middle strike price to create the "wings."

Two aspects of this strategy differ from the basic spread of butterflies. First, the credit spread pays a net premium to an investor at inception, while the essential butterfly position has been defined as a type of debit spread. Secondly, instead of three, the strategy calls for four contracts.

The iron butterflies limit the possible gains and losses. They shall enable traders to maintain at least a part of the net premium initially paid, which will occur if the price of the underlying security or index closes between the upper and lower strike prices. At times of lower volatility, when market participants believe that an instrument will remain in the same price range until its option expiration date, they apply this strategy.

The higher the profit, the nearer the middle strike price the underlying closes at the end of the contract. The trader shall incur a loss if the price closes below or above the strike price of an upper call or lower put. Adding and subtracting the premium received at the middle strike price can determine the breakeven point.

To understand the iron fly strategy calculation, refer to the example below.

Let's say a company's stock has traded at Rs. 100. So let's make four trades to build an iron butterfly. Suppose that there are a lot of 100 shares in each of the options mentioned above.

  • You're buying one put option with a strike price of Rs. 95, and the cost is Rs. 120. You are selling one put option for a strike price of Rs.
  • For a price of Rs. 320, 100 for a price of Rs. 320.
  • With a strike price of Rupees, you're selling a one-call option.
  • 100 (for a price of Rs. 330) With a strike price of Rs 105, you'll buy one call option at Rs 140.

Since you received Rs. 650 for the options you sold and spent Rs. 260 for the options you bought, your initial overall gain is Rs. 390. This indicates that you have a total credit. Here's what will happen at expiration if the underlying stock price closes at the strike price of the short options, which is Rs. 100.

  • If option 1 provides you with the right to sell at a price of INR 95 instead of Rs. 100, it will expire worthless.
  • Given that Option 2 grants the buyer the option to sell for Rs. 100 (the same as the market price), it would expire worthless.
  • Since Option 3 provides the investor with a right to purchase at 100 INR, which is identical to the retail price, that option expires worthless.
  • Since Option 4 gives you the right to buy at a price of 105, instead of 100, it will expire worthless.

Therefore, if you use the iron butterfly method in this case, you will have an initial profit of Rs. 390. On the other hand, there is a greater risk of loss if the stock closes below the lower or above the higher strike price. Therefore, an option strategy with iron butterflies would be more appropriate for scenarios in which the market is relatively calm.

The advantages of the iron fly strategy is essential to know before applying these strategies in any real life trade.

1. Minimum capital needed A relatively small equity commitment is required to implement an iron butterfly strategy. As compared to different directional spreads, it offers a stable income.

2. If the range is exceeded A trader may decide to terminate part of their position if the underlying price moves out of a defined range and continues to hold an additional bull put or bear call spread. To mitigate losses, the trader may also have the option of placing or unwinding a position.

3. Pre-defined profit and loss The fact that investors can make informed decisions on the risk and reward involved is a vital benefit of this strategy.

Conclusion

The most suitable strategy for traders with experience is the Iron Butterfly Strategy. The gains are on top when the stock price is at the centre strike value. Well, it seems evident that the ideal place is in a narrow range. Therefore, much expertise is needed to get this options trading strategy right. Again, during periods of volatile market conditions, it would be best to avoid this strategy. To start options trading safely and securely, go ahead with the Kotak Securities app.

FAQs On Iron Fly Strategy

There are several critical advantages to iron butterflies. It may generate a stable income and reduce the risks as much as possible compared with directional spreads, using very little capital.

There is a 20% to 30% probability of an iron butterfly achieving any profit. It makes an entire profit only 23% of the time. This means the trader would receive a maximum of 2 weeks' profit.

A neutral options trading strategy is an iron butterfly. The iron butterflies defined the risk and limited profitability potential. There are four legs in the iron butterfly, consisting of two put options and two call options.

The purchase of other options reduces the income from the sale option, but it can still be a profitable strategy if it is properly exploited. A bull put spread and a bear call spread, with an identical expiration date, are part of Iron Butterfly's trading strategy. A risk graph resembles a butterfly.

Iron butterfly traders will profit on the expiry day if the price is within a range concerning the central strike price. The price at which the trader sells both a call option and a put option, a short strangle option, is the centre strike.

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