An advanced options strategy known as an iron butterfly spread has three legs and four total choices. Joining a bull put spread with a bear call spread at strike price B constitutes the transaction. An iron butterfly can also be viewed as an iron condor, with the difference being that the short strikes, for both calls and puts, are at the same strike price as opposed to being spread apart. The investor is short both the put and the call spread, therefore the trade is set up for a total net credit.
An investor who opens this position is making a wager that the stock will pin or almost pin at strike price B. All of the options would expire worthless and the investor would keep the whole premium amount if the stock did pin at the short strikes.
The stock’s position in relation to the short strikes at the time the trade is opened can make it slightly bullish or bearish, however generally speaking this trade is a natural direction approach. If the stock is trading below strike price B, it is bullish; if it is trading above strike price B, it is bearish.
Profit/Loss
The maximum profit would be equal to the credit obtained for opening the trade, or Rs 3.40 in this example. This profit would be realised if the stock remained at the short strike prices on the expiration date.
The difference between the lower strike price and the intermediate strike price is subtracted from the credit of the trade to determine the maximum loss. For instance, the maximum loss would be Rs 1.60 if the distance between points A and B was Rs 5 and the premium received was Rs 3.40.
Breakeven
There are two points where things break even. By adding the premium obtained for the trade to the short strike price (point B), the higher breakeven point can be determined. Therefore, the higher breakeven would be Rs 103.40 if point B had a 100-strike price option and the credit earned was Rs 3.40.
By subtracting the premium earned for the trade from the short strike price (point B), one can determine the lower breakeven point. Because of this, if point B represented a 100-strike price option and the credit received was Rs 3.40, the lower breakeven would be Rs 96.60.
Example
A trader could execute a 95/100/105 iron butterfly spread by purchasing one 95-strike price put, selling one 100-strike price put, purchasing one 105-strike price call, and XYZ is trading at Rs 100 and is predicted to trade sideways over the next 45 days.
- For Rs 0.50, purchase 1 XYZ 95-strike price put.
- For Rs 2.20, sell 1 XYZ 100-strike price put.
- For Rs 2.20, sell 1 XYZ 100-strike price call.
- Purchase 1 105-strike price call for XYZ for Rs 0.50.
- Total premium equals Rs 3.40 in credit.
The investor will keep the Rs 3.40 credit if the stock reaches Rs 100 at expiration, but all positions will expire worthless and be deleted from the account.
The trader will lose Rs 5 on the short 100 put if the stock moves lower than Rs 95 at expiration, while all other options expire worthless. The trader’s net loss would be Rs 1.60 because they were given a credit of Rs 3.40.
The investor would lose Rs 2 on the 100-strike call if the stock reached Rs 102 and all other options would expire worthless. The trader’s net profit would be Rs 1.40 because they were given a credit of Rs 3.40.
Conclusion
The implied volatility is sensitive to variations in this kind of spread. When implied volatility grows, the spread’s net price rises, and when implied volatility declines, the price lowers. The trader who places this order hopes that implied volatility will decline since it will enable them to repurchase the trade at a lower cost.
This transaction is frequently made just before earnings, when implied volatility is high. Once the earnings report is released and implied volatility decreases, the spread’s value decreases, allowing the investor to repurchase it at a lower price. However, if there is a sizable earnings gap, a huge price fluctuation might quickly turn this strategy into a loser. Due to its great profitability and low risk, it is a preferred investment among traders.
The iron butterfly spread is a strategy for seasoned options traders only; it is not advised for beginners.
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