Short Iron Butterfly: Understanding This Advanced Options Trading Strategy
For investors seeking an options strategy for a neutral range, one advanced one to consider is the short iron butterfly. This strategy has been created to potentially benefit from either stocks or futures prices moving within a specific range. Its goal is to potentially profit from prices remaining fairly stable but it does require careful planning and monitoring.
Read on to learn more.
What is a short iron butterfly
A short iron butterfly strategy combines a bull put spread (buying a put and selling a put) and a bear call spread (buying a call and selling a call). This includes a short call and a short put having the same strike price that are sold at or closer to the current market price of the underlying stock; all four options have the same expiration with three different strike prices that are equidistant. This strategy results in a net credit with a limited theoretical potential profit and loss.
Why consider the short iron butterfly: How it works
Using the same strike price for the short put and short call and the same expiration date for all the options, here's how a short iron butterfly is opened.
Bull put spread: Sell a put option and buy another put option with a lower strike price. The goal here is to potentially profit from the underlying stock price staying close to the strike price of the sold put.
Bear call spread: Sell a call option and buy another call option with a higher strike price. The goal here is to potentially profit from the underlying stock price staying close to the strike price of the sold call.
Short iron butterfly example
Here's an example.
Bull put spread:
Buy 1 85 Put at $1.20
Sell 1 90 Put at $3.20
Bear call spread:
Sell 1 90 Call at $3.30
Buy 1 95 Call at $1.40
The net credit received is $3.90 (3.20 +3.30 - 1.20 - 1.4).
Short iron butterfly profit and loss
Theoretical max profit
The theoretical maximum profit potential for a short iron butterfly is the net credit received minus any commissions. This profit is fully realized if the stock price matches the strike price of the short options (the center strike) at expiration. In this scenario, all options expire worthless, enabling the trader to retain the net credit as income. For this example, this would occur if the underlying security was $90 upon expiration.
Theoretical max loss
The theoretical maximum loss is the difference between the lowest and middle strike prices, minus the net credit received. From this example, if the difference between these strike prices is $5.00 and the net credit received is $3.90 (excluding commissions), the theoretical maximum loss is $1.10.
Maximum potential loss and profit for options are calculated based on the single leg or an entire multi-leg trade remaining intact until expiration with no option contracts being exercised or assigned. These figures do not account for a portion of a multi-leg strategy being changed or removed or the trader assuming a short or long position in the underlying stock at or before expiration. Therefore, it is possible to lose more than the theoretical max loss of a strategy.
Breakeven points
The breakeven points for the short iron butterfly includes two breakeven points.
Lower breakeven point: This is equal to taking the center strike minus the net credit received from creating the trade. For this example, it's $90 - $3.90 = $86.10.
Upper breakeven point: This is equal to center strike price plus the net credit received. For this example, it's $90 + $3.90 = $93.90.
Time decay
Time decay (theta) is a critical factor in options trading, including short iron butterfly strategies. Options generally lose value as time passes due to the diminishing time left until expiration.
For a short iron butterfly strategy, it maintains a net positive theta (time decay) when the stock price stays between the lowest and highest strike prices. As a result, this strategy usually benefits from the passage of time, with potential profits accruing as options lose their extrinsic value. However, if the stock price shifts beyond the range of the strike prices, the theta turns negative, leading to potential losses as expiration nears.
How to set up a short iron butterfly strategy using moomoo
Moomoo provides a user-friendly platform for trading options. Here's a step-by-step guide to get you started:
Step 1: Navigate to your Watchlist, then select a stock's "Detailed Quotes" page.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 2: Navigate to Options> Chain located at the top of the page.
Step 3: By default, all options with a specific expiration date are shown. For selective viewing of calls or puts, simply tap "Call/Put."
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 4: Adjust the expiration date by choosing your preferred date from the menu.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 5: Easily distinguish between options: white denotes out-of-the-money, and blue indicates in-the-money. Swipe horizontally to access additional option details.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 6: Explore various trading strategies at the screen's bottom, offering flexibility for your investment approach.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
When to use a short iron butterfly
Traders might consider using a short iron butterfly strategy in the following situations:
Low volatility: A short iron butterfly generally has more potential for profit when the underlying asset's price remains relatively stable and doesn't move much. An investor anticipating a period of low volatility in the underlying asset might employ this strategy.
Neutral market outlook: The short iron butterfly is a neutral options trading strategy, meaning it can be profitable if the price of the underlying asset end ups within a certain range at expiration. If an investor doesn't have a strong directional bias and believes the underlying asset will stay within a specific price range, they might use a short iron butterfly to potentially profit from this scenario.
Limited risk, limited reward preference: The short iron butterfly is a limited risk, limited reward strategy, assuming no contracts are exercised or assigned. Traders define their maximum potential loss upfront.
Premium collection: By simultaneously selling options and collecting premiums, an investor can generate income upfront.
Options decay: Since a short iron butterfly benefits from options decay (time decay), it can be advantageous to use this strategy when expecting a decrease in implied volatility.
When to close a short iron butterfly
Closing a short iron butterfly position is typically done under circumstances to manage risk or capture potential profits. Ultimately, the decision to close a short iron butterfly position depends on the investor's individual trading objectives, risk tolerance, and assessment of market conditions. This requires regularly monitoring positions and making potential changes.
Here are some situations in which an investor might consider closing a short iron butterfly:
Nearing expiration: As the expiration date approaches, especially if the price of the underlying asset is close to one of the breakeven points, an investor may want to close the position to avoid the risk of the options expiring in-the-money. Closing the position allows the investor to limit potential losses.
Achieving target profit: If the price of the underlying asset moves within the desired range and the short iron butterfly has reached a significant portion of its theoretical maximum potential profit, the investor might choose to close the position to lock in those gains.
Changing market conditions: If market conditions change, causing increased volatility or a significant move in the price of the underlying asset, it may be prudent to close the short iron butterfly position to limit potential losses or take advantage of possible new trading opportunities.
Avoiding assignment: If the options are in-the-money as expiration approaches, there's a risk of assignment, especially if the investor doesn't want to buy or sell the underlying asset. Closing the position before expiration can help avoid this risk.
Rebalancing portfolio: If the short iron butterfly was part of a broader options trading strategy or portfolio, closing the position may be part of a larger rebalancing effort to manage overall risk or exposure.
Potential pros and cons of a short iron butterfly
The short iron butterfly options strategy, like any trading strategy, has its own set of advantages and disadvantages.
Pros
Defined loss potential: A primary advantage of a short iron butterfly is that it offers defined loss potential as the theoretical maximum potential loss is defined when establishing the position.
Defined profit potential: Similar to the limited risk, the short iron butterfly also offers defined profit potential. Traders know the theoretical maximum profit they can achieve when entering the position, so they have the ability to gauge risk vs. reward.
Profit from low volatility: The short iron butterfly can be profitable when the underlying asset's price remains relatively stable and doesn't experience significant movements.
Premium collection: By selling options and collecting premiums, traders can generate income upfront.
Neutral strategy: The short iron butterfly is a neutral options trading strategy, meaning it can profit if the price of the underlying asset remains within a specific range and enabling traders to not have a strong directional bias.
Cons
Complexity: Involves multiple options contracts with different strike prices, which can make it more complex than simpler options strategies.
Commission costs: With its multiple legs (buying and selling multiple options contracts), transaction costs such as commissions can eat into potential profits. Traders need to consider these costs when evaluating the strategy's viability.
Market conditions: The short iron butterfly is most effective in low volatility environments where the price of the underlying asset remains relatively stable while in high volatility environments or during periods of significant market movements, this strategy may be less effective or result in losses.
Short Iron Butterfly vs. Short Iron Condor: What's the difference
Both the short iron condor and the short iron butterfly are neutral options trading strategies that involve multiple options contracts; they are both used in neutral market conditions. However, there are key differences between the two in terms of structure, risk-reward profile, and profit potential. Here's a closer review.
Structure
A short iron condor (also know as a short condor) is a neutral four-part options trading strategy that involves simultaneous buying and selling options with the same expiration date and underlying instrument. There's four options with two parts: a bear call spread and a bull put spread. The bear call spread setup: Sell a call with a strike price above the underlying stock price and buy a further out-of-the-money call option. The bull put spread involves selling a put below the underlying stock price and buying a further out-of-the-money put option.
In a short iron butterfly, the trader simultaneously sells an at-the-money (ATM) call option and an ATM put option, while also buying an OTM call option with a higher strike price and an OTM put option with a lower strike price. The sold call and put options are at the same strike price, while the bought call and put options are equidistant from the sold options.
Strike prices
The short iron condor uses options with strike prices further away from the current market price of the underlying asset, resulting in a wider range for the strategy to be potentially profitable. The short iron butterfly uses options with strike prices closer to the current market price of the underlying asset, resulting in a narrower range for the strategy to be potentially profitable.
Profit potential
The short iron condor has a wider profit range compared to the iron butterfly because it involves selling options further away from the current market price. However, the theoretical maximum potential profit is also lower compared to the short iron butterfly.
Risk-Reward profile
The short iron condor and short iron butterfly's risk-reward profiles are characterized by limited potential profit and limited potential loss. A short iron condor potentially profits if the price of the underlying asset remains within a certain range until expiration. A short iron butterfly's potential profit range is narrower compared to the iron condor due to the closer proximity of the sold options to the current market price.
FAQs about the short iron butterfly options strategy
How can you potentially profit from iron butterfly spread?
An investor can potentially profit from a short iron butterfly spread by correctly anticipating the price movement of the underlying asset and implementing the strategy in a way that seeks to maximize potential gains. Here's a look:
Correct price range forecasting: Accurately assessing that the price of the underlying asset will remain within a certain range until expiration. This range is determined by the strike prices of the options involved in the spread.
Premium collection: An investor collects premiums from selling both call and put options when constructing the short iron butterfly. These premiums represent immediate income for the investor, and to potentially profit from the spread, the investor wants the options they've sold to expire worthless, allowing them to keep the premiums.
Time decay (theta): Options lose value as time passes due to time decay (theta). Since the short iron butterfly involves selling options with the same expiration date, the investor profits as time passes if the price of the underlying asset remains within the range defined by the strike prices; the options they sold will lose value due to time decay.
Volatility reduction: The short iron butterfly benefits from a decrease in implied volatility. As the value of the options decreases, it can allow the investor to buy them back at a lower price or let them expire worthless.
Close the spread at a potential profit: If the price of the underlying asset remains within the expected range until expiration, and both the call and put options sold as part of the spread expire worthless, the investor can close the spread by buying back the options they've sold (if not already done automatically by the options expiring worthless). This allows the investor to realize the profit generated from the initial premium collected and avoids taking the options into expiration, which open up more risks.
Monitor and manage: Throughout a short iron butterfly's spread lifetime, the investor should monitor market conditions, the price of the underlying asset, and any changes in implied volatility. Depending on these factors, the investor may choose to adjust or close the position before expiration to lock in potential profits or minimize losses.
Is the short iron butterfly better than the short iron condor?
Whether the short iron butterfly or the iron condor is "better" depends on various factors, including the investor's market outlook, risk tolerance, and trading objectives. Both strategies have their own advantages and disadvantages, and the choice between them ultimately depends on the specific circumstances and preferences of the investor. Here's a few considerations.
The short iron butterfly has a narrower profit range compared to an short iron condor. It also generally offers a higher maximum potential profit but this requires the underlying asset price to be at the short strike price at expiration. The short iron butterfly does have a lower risk-reward ratio vs an iron condor.
Some investors may prefer the short iron butterfly for its higher potential profit and higher probability of profit because the strike prices are closer to the current stock price, while others may prefer the iron condor for its wider profit range and potentially higher risk-reward ratio. It's essential for investors to carefully evaluate their objectives and market conditions before choosing between these strategies.
What is the success rate of the short iron butterfly strategy?
The success rate of the short iron butterfly strategy can vary depending on different factors, including market conditions, the investor's ability to accurately predict price movements, and how the strategy is implemented. Overall, there is no definitive "success rate" for the short iron butterfly strategy; however, investors can improve their potential chances of success by carefully considering the above factors and remember that options trading involves risks; past performance is not indicative of future results. Multi-leg strategies are complex and they are not appropriate for all investors.
Is the short iron butterfly a good strategy?
The short iron butterfly is a popular options trading strategy that involves combining both call and put options to create a range-bound position that results in a net credit. The primary goal of the short iron butterfly is to capitalize on low volatility and time decay, making it appealing in stable market conditions. It can be a good strategy for some traders with a neutral outlook on the market and preference for defined risk and reward. However, traders must be mindful of the potential for losses in volatile markets and try to monitor and manage their positions effectively.
