Iron butterfly

Article contents



At a glance



Setting up the strategy


  1. Buy one out-of-the-money put with a lower strike price.

  2. Sell one at-the-money put.

  3. Sell one at-the-money call, with the same strike as the at-the-money put.

  4. Buy one out-of-the-money call with a higher strike price.
At expiration, you want the stock price to close at the strike prices of the higher strike put and lower strike call, so they expire worthless.

Who should run this?


Advanced traders only.

Margin requirements


Learn more about Questrade’s option margin requirements.

Strategy overview



An iron butterfly is an options strategy in which a trader simultaneously does the following:

  • Buys one out-of-the-money put with a lower strike price
  • Sells one at-the-money put
  • Sells one at-the-money call
  • Buys one out-of-the-money call with a higher strike price

Market outlook


  • Neutral

Strategy benefits


  • Can still profit if the stock remains stagnant.
  • Credit spread helps reduce the overall risk. 
  • Maximum loss and maximum profit can be accurately estimated.

Strategy downsides


  • Limited profit potential from the narrow trading range made up of the two wing strike prices.
  • Credit received may not cover the maximum risk.

Iron butterfly example



Scenario

ABC shares are currently trading at $28 in March 2013, and you believe the stock will remain within a tight trading range over the next 30 days. To set up an iron butterfly strategy, you do the following:


  • Buy one $22 April put for $11 ($0.11 premium x 100 shares)
  • Sell one $28 April put for $141 ($1.41 premium x 100 shares)
  • Sell one $28 April call for $140 ($1.40 premium x 100 shares)
  • Buy one $34 April call for $8 ($0.08 premium x 100 shares)
After initiating the trade, you will receive a $262 credit.


Possible results


  1. At expiration, the stock drops to $20. In this case the 22 long put and 28 short put would finish in the money and would have a $600 intrinsic value. After subtracting your initial credit of $262, your total loss would be $338.

  2. Upon expiration in April, the stock continues to trade at $28. As a result, all options would expire worthless, and you would get to keep the entire $262 credit.

  3. The stock rises to $36 at expiration, meaning the 28 call and 34 call options would finish in the money. In this case, the 28 call would be exercised by the buyer at $2800. In turn, you would exercise the 34 call option to leave your losses at $600. After applying the $262 credit you received to initially enter the trade, your total losses would be $338.

Profit and loss explained



Maximum profit

Maximum profit = net credit received

Maximum loss

Maximum loss = long call strike price – short call strike price - net credit received

Break-even at expiration

There are two break-even points at expiration:

  • Break-even point #1= short call strike price + net credit received
  • Break-even point #2 = short put strike price – net credit received

Sample calculations



  • Stock value at start of strategy: $28
  • To execute the strategy: Buy $22 put option for $11, Sell $28 put option for $141, Sell $28 call  option for $140, Buy $34 call option for $8
  • Result: $262 net credit
Stock price at expiration Profit and loss calculations 
$20 In this case, both put options would expire in the money. The trade transaction would look like this:

$22 (long put) x 100 (number of shares)
– $28 (short put) x 100 (number of shares)
+ $262 (net credit received to initiate the strategy)
= $338 loss
$28 All options would expire worthless. The trade transaction would look like this:

$1.41 (option premium received for selling the higher strike put)
x 100 (number of shares)
+ $1.40 (option premium received for selling the lower strike call)
$0.11 (option premium paid for buying the lower strike put)
x 100 (number of shares)
–  $0.08 (option premium paid for buying the higher strike call)
100 (number of shares)
= $262 profit

$36 In this case, the two call options would finish in the money. The trade transaction would look like this:

$28 (lower call strike price)
x 100 (number of shares)
–    $34 (higher call strike price)
x 100 (number of shares)
+ $162 (net credit received to initiate the strategy)
= $338 loss



Note
: commission fees are not included in the above calculations.


Payoff diagram






Creating an iron butterfly







Standard order details

Order detail

Description

Symbol lookup field

Click  and change the mode to . Then enter the symbol you want to buy or sell. The default expiration date, strike price, and strategy appear. 




Tip: click the Option tab to view a more detailed option quote.

Modify the expiration date, strike price, and option strategy accordingly. For more information, see Elements of an option quote.
Action

The buy or sell action is set for you when you select the strategy type.

Qty

Select a value using the arrows , or enter a value manually.

Note: by default, the quantity will be populated with the value set in your user preferences.
Order type Select the type of order you want to submit. When creating strategy orders, only Limit or Market order types are available. For more information, see Order types.

The limit order type requires you to fill in additional fields. Refer to the table section below for details.
Duration

Select a duration to specify how long the order should remain active. For more information, see Order durations.

Route Select a route or leave the selection at Auto to let the platform determine the best one. Canadian routes will be listed for Canadian symbols and U.S. routes will be listed for U.S symbols.
Sub-route

This field will be filtered according to the route selection. It indicates where you prefer the order to be executed. Leave the selection at Auto to let the platform determine the best route.

Note: sub-route selection is only available for Canadian symbols.
Order type-specific details
Limit price Enter your limit price:

  • To have the price fluctuate according to real-time data, select . The icon changes to a lock icon , which locks the limit price. Once locked, use the refresh button to automatically update your limit price.
  • To choose a custom price, select .
Note: if real-time market data is not available, the limit price will be blank and the float limit icon will be unlocked.






Note: the video tutorial above shows how to create an iron butterfly strategy using IQ Edge; however, the principles are the same for IQ Web.
Tip: for an optimized viewing experience, watch the video on YouTube in full 720p HD. To open the video in YouTube, click the YouTube button in the bottom right corner of the video window and select the change settings icon to modify the video quality.


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