Definition
An Iron Butterfly is an advanced options trading strategy designed to profit from low volatility in the underlying asset. It involves creating a total of four options contracts, comprising two at-the-money options, one out-of-the-money call option, and one out-of-the-money put option. The goal is for the underlying asset’s price to remain as stable as possible for maximum profitability.
Key Takeaways
- The Iron Butterfly is a complex options trading strategy which is designed to return a certain fixed profit when the price of the underlying asset is perceived to lack volatility or remain stagnant.
- It is constructed by combining a bear call spread and a bull put spread. This involves four different contract types: Buying and selling a call, and buying and selling a put, all with the same expiration date but with differing strike prices.
- Even though Iron Butterfly has potential for high returns, it also carries a significant amount of risk. If the underlying asset’s price deviates significantly from the strike price, heavy losses may occur. Therefore, it’s a strategy that’s generally used by more experienced traders.
Importance
The finance term “Iron Butterfly” is significant as it’s used to describe a non-directional options strategy that is designed to have a high probability of earning a limited profit when the future volatility of the underlying asset is expected to be lower than the implied volatility when long or short positions are placed in the market.
It combines both bear call and bull put spreads to minimize risk and maximize profits.
This strategy involves four options contracts with the same expiration date but different strike prices, and is commonly used in options trading because it allows traders to potentially make profit regardless of market fluctuations, provided the price of the underlying asset stays within a specified range until expiration.
Its risk management capability makes it an important strategy for options traders.
Explanation
The Iron Butterfly is a sophisticated financial instrument mainly utilized by experienced traders to harness potential benefits from the market volatility. Essentially, it’s a type of options strategy used to earn a profit when the investor predicts that the price of a particular security will remain relatively stable in the short term.
It involves creating a range, or “the wings,” within which the security’s price will fluctuate, and where maximum profit can be achieved. Iron Butterfly strategy involves the simultaneous buying and selling of call and put options and is structured to create a balance between the risks and potential rewards.
The purpose of this strategy is to capitalise on low volatility in asset prices. Traders use this strategies when they expect that an underlying asset will not exhibit large price swings, thus enabling them to profit from an essentially stable market.
If the asset’s price at the expiry of the options contracts is within the trader’s predicted range, they stand to make a considerable return. Conversely, if the price moves outside of this range, the losses could potentially be significant as well.
Examples of Iron Butterfly
The term “Iron Butterfly” is an options trading strategy with the goal to achieve a tight range of profit with limited risk. Here are three real-world examples:Stock Market Scenario: Suppose a trader believes that the stock of company X, currently trading at $100 per share, will not experience significant price movement in the next month. The trader could create an iron butterfly strategy by selling a call option and a put option at the $100 strike price, then buying a call option at a higher strike price (say $105) and a put option at a lower strike price (say $95). If the stock stays close to $100, both the call and the put options sold will expire worthless and the trader will pocket the premium.
Tech Start-Up Scenario: Take a more volatile industry such as technology startups. Let’s assume the current market value of a start-up is $200 per share. An investor predicts that the stock will not experience significant change after a major product release. They could implement an iron butterfly strategy setting the strike price at $200, and setting protective boundaries at $210 and $At the expiration of the options, if the share price remains near $200, they could potentially profit from the premiums of the sold options.
Investing in Index Funds Scenario: Consider an investor with a diversified portfolio in index funds, ETFs or a large single company e.g. Apple Inc. Currently, the market price for one share is $The investor assumes there will be little fluctuation in the stock price by the end of the quarter. To capitalize on this, they can set up an iron butterfly strategy, setting the strike price at $500 with call and put options set at $510 and $490, respectively. As such, they stand to gain revenues from the options’ premiums if their assumption about the market price holds true.
Iron Butterfly FAQs
What is an Iron Butterfly?
An Iron Butterfly is a combination of contracts that form an options strategy designed to profit from low volatility in the underlying asset. It involves a simultaneous long and short position, along with purchasing an at-the-money put and call option with the same strike price and expiration date.
How does an Iron Butterfly make money?
Iron Butterfly makes money when the underlying asset’s price upon expiration is equal to the strike price of the long and short options. The maximum profit is equal to the credit received when entering the position.
What is the risk in an Iron Butterfly strategy?
The risk of an Iron Butterfly strategy is limited to the width of the wings (the higher and lower strike options) minus the credit received when entering the position.
When should you use an Iron Butterfly strategy?
The Iron Butterfly strategy should be used when a trader has a neutral outlook and expects the underlying asset to trade within a specific range until its expiration.
What is the difference between Iron Butterfly and Iron Condor?
The primary difference between the Iron Butterfly and the Iron Condor strategy is the potential profit and risk. The Iron Butterfly has a higher maximum profit but also a higher risk if the underlying asset’s price deviates much from the strike price.
Related Entrepreneurship Terms
- Options Trading
- Straddle
- Strike Price
- Market Volatility
- Risk Management
Sources for More Information
- Investopedia: A comprehensive resource covering all aspects of financial investing, including detailed explanations of an Iron Butterfly.
- Fidelity Investments: A major brokerage firm that provides educational resources and trading tools on popular investment strategies such as Iron Butterfly.
- Charles Schwab: Another prominent investment firm that can provide insights and tools on Iron Butterfly trading strategy.
- NerdWallet: A personal finance site that covers a broad range of topics including investing strategies like Iron Butterfly.
