Iron Butterfly Option Strategy
The Iron Butterfly Option strategy is a popular trading strategy that is designed to profit from a security's price range over a period. This strategy is also known as a neutral strategy as it is used when a trader expects the price of an asset to remain stable within a specific range. In this blog, we will explain the Iron Butterfly Option strategy in detail, including what it is, how it works, and when to use it.
What is an Iron Butterfly Options Strategy?
An Iron Butterfly Option strategy is a combination of four options contracts that are placed on the same underlying asset. It consists of two calls and two puts, each with the same strike price. The strike price is the price at which the option contract can be exercised. The Iron Butterfly Option strategy is designed to profit from a security's price range over a period, usually a few days or weeks.
The Iron Butterfly Option strategy involves the purchase of an at-the-money call option and an at-the-money put option, along with the sale of an out-of-the-money call option and an out-of-the-money put option. The call options allow the trader to buy the underlying asset at a specific price, while the put options allow the trader to sell the underlying asset at a specific price.
How does an Iron Butterfly Options Strategy work?
The Iron Butterfly Option strategy works by creating a range of profit for the trader. This range is determined by the strike price of the options. If the price of the underlying asset falls within this range, the trader will make a profit. If the price of the underlying asset moves outside this range, the trader will incur a loss.
The Iron Butterfly Option strategy is designed to be a non-directional strategy, meaning that it can be profitable regardless of the direction the price of the underlying asset moves. However, it is essential to note that the strategy has a limited profit potential and a limited loss potential.
When to use an Iron Butterfly Options Strategy?
An Iron Butterfly Option strategy is best used when a trader expects the price of the underlying asset to remain stable within a specific range over a period. This strategy is useful in a market that is not trending in any particular direction. It is also an effective strategy when a trader expects a security's price to remain within a range but is unsure about the direction of the move.
An Iron Butterfly Option strategy is a popular strategy for trading stocks, indices, and commodities. It is often used by traders who want to take advantage of a range-bound market but do not want to take a directional position.
Max profit and max loss in Iron Butterfly Option strategy
The maximum profit and maximum loss in the Iron Butterfly Option strategy are both limited and predetermined at the time of initiating the trade.
The maximum profit is achieved when the price of the underlying asset at expiration is equal to the strike price of the short call and put options. In this scenario, both the call and put options will expire worthless, and the trader will earn the net premium received from selling the options.
The formula to calculate the maximum profit is: Maximum Profit = Net Premium Received - Commissions Paid
The maximum loss in the Iron Butterfly Option strategy occurs when the price of the underlying asset at expiration is above the strike price of the short call option or below the strike price of the short put option. In this scenario, the trader will have to either exercise the short option or buy back the option at a higher price to limit the loss.
The formula to calculate the maximum loss is: Maximum Loss = Difference in Strike Price - Net Premium Received + Commissions Paid
It is important to note that both the maximum profit and maximum loss are limited in the Iron Butterfly Option strategy. This makes it a popular strategy among traders who want to limit their risk while still taking advantage of a range-bound market.
Benefits and Risks of the Iron Butterfly Options Strategy:
Benefits:
- Non-directional strategy
- Profitable in a range-bound market
- Limited loss potential
Risks:
- Limited profit potential
- Losses can occur if the price of the underlying asset moves outside the range
- Can be complicated for beginner traders
Example:
Let us consider an example of the Iron Butterfly Option strategy using an Indian stock ABC trading at INR 100.
- Buy one call option with a strike price of INR 100 for INR 5
- Buy one put option with a strike price of INR 100 for INR 5
- Sell one call option with a strike price of INR 105 for INR 2.5
- Sell one put option with a strike price of INR 95 for INR 2.5
The maximum profit potential for this trade is INR 2.5, which is the net premium received from selling the call and put options. The maximum loss potential is INR 5, which is the premium paid for the call and put options.
If the price of ABC stock remains between INR 95 and INR 105 at expiration, the trader will earn the maximum profit of INR 2.5. If the price of the stock moves outside this range, the trader will incur a loss. For example, if the price of the stock falls below INR 95, the put option will be exercised, and the trader will start incurring losses. Similarly, if the price of the stock rises above INR 105, the call option will be exercised, and the trader will incur losses.
Conclusion:
The Iron Butterfly Option strategy is a popular trading strategy used by traders who expect the price of an underlying asset to remain stable within a specific range. It is a non-directional strategy that can be profitable regardless of the direction of the price movement. However, the strategy has a limited profit potential and a limited loss potential. It is essential to consider the risks and benefits of this strategy before using it for trading. Traders should also have a good understanding of options trading before using this strategy.
Learn Option series next reads: