How It Works
The iron butterfly strategy has four options: selling an at-the-money (ATM) put, buying an out-of-the-money (OTM) put, selling an ATM call, and purchasing an OTM call. All of these options have the same expiration date and are linked to the same underlying asset. This strategy essentially combines a short straddle (selling both the ATM call and put) and a long strangle (purchasing both the OTM call and put), resulting in protective “wings.”
Objective
The iron butterfly aims to profit from the underlying asset’s low volatility and tiny price swings. By selling the ATM options, the investor earns premium income that is somewhat offset by the cost of purchasing the OTM options. The technique is intended to capitalize on the time decay of options and is best suited for scenarios in which the stock is projected to remain fairly stable.
Risk and Rewards
The iron butterfly limits potential profit and loss to a fixed range established by the strike prices of the options involved. The highest profit is realized when the underlying asset’s price at expiration matches the strike price of the ATM options traded. This profit is equal to the net premium collected (the premiums received from sold options less the premiums paid for bought options).
In contrast, the maximum loss is limited and happens when the price of the underlying asset moves far beyond the strike prices of the OTM options acquired. Investors choose this approach because it generates income from the premiums received from sold options and has a high probability of a minor gain, assuming the stock remains non-volatile. The protective OTM options acquired (the “wings”) provide protection against limitless losses that might otherwise occur with a simple short straddle strategy.
As you can see from the P&L graph above, the most profit is realized when the stock stays at the at-the-money strikes of the put and call options that are sold. The entire net premium earned represents the maximum gain. The stock goes above the long call strike or below the long put strike, resulting in the maximum loss.
