NEUTRAL (OR RANGE-BASED) INCOME STRATEGY
An Iron Butterfly is a four-leg options trade where we sell a Credit Call Spread and simultaneously sell a Credit Put Spread. Unlike an Iron Condor where the short strikes of each of these credit spreads are set apart, with an Iron Butterfly, the short Call and short Put are set at the same strike. As a result, the Iron Butterfly also resembles a short Straddle strategy combined with a long out-the-money Call and Put beyond each short strike, to limit risk. The strategy has defined risk and defined reward.
Since we are selling both Calls and Puts, we are taking a view that a stock will stay within a range (our zone of profitability) at expiration.
It is commonly used as an income generating strategy by investors with a generally neutral view, or who are expecting a significant drop in volatility (such as after an earnings event). The Iron Butterfly typically offers a probability of profit greater than 50% but a low probability of realizing maximum profit.
The Iron Butterfly is often compared to another four-leg neutral option strategy – the Iron Condor.
It might also be used as an alternative to a short Straddle by investors who are willing to accept somewhat less premium (income) in return for creating a defined risk position with protection against a sharp move higher or lower in the underlying stock.
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To look more closely at the Iron Butterfly and how it might be as an income generating strategy, we’ll take a hypothetical example using SPY.
Credit Call Spread + Credit Put Spread
We’ve seen how a Credit Call Spread can be seen as a strategy that profits if a stock stays below a certain level and a Credit Put Spread one that profits if a stock stays above a certain level. Therefore, if we simultaneously trade these spreads using the same strike price for both the short Call and short Put, it follows that we have a strategy where maximum gain is realized at a single level (the short strike price) and diminishing profits may be realized out to our upper and lower breakeven levels (or within a range) – the Iron Butterfly.
By opening two Credit Spreads, each selling a relatively high-value at-the-money (or close to at-the-money) option and buying a relatively low-cost out-the-money option, we collect a relatively large amount of net premium (or income). This often makes the risk to reward ratio of an Iron Butterfly look relatively attractive.
In addition, if we are wrong, we can only incur maximum loss on one spread, since the stock cannot end up both above and below each of our breakevens. So, by combining spreads into an Iron Butterfly, we typically generate incremental income and improve our risk to reward ratio relative to a stand-alone Credit Call or Put Spread, in return for accepting a precise point of maximum gain and a defined zone of profitability.
Taking a hypothetical example using SPY, we start by establishing levels at which we believe the stock will find support in a downward move and resistance in an upwards move. This range or zone of profitability is typically set equidistant from the current underlying stock price, although it may also be centered on a slightly bullish or bearish price target.
To inform our decision in this example, we decide to look at the expected move for our timeframe – a move of around 3.5% higher or lower than the current stock price.
With this in mind and with the stock currently trading around $383, we decide to set the short strikes of each our Credit Call and Credit Put Spread legs (or ‘guts’ of our Iron Butterfly) at-the money (383 strike) and the long strikes (or ‘wings’) approximately 3.5% higher and lower – at 396 and 370 respectively.
As we have seen, deciding where to set the short option leg(s) of any spread relative to the current stock price and how wide to set the spread(s), is a balancing act of risk, reward and probability of profit. Since the two short option legs of an Iron Butterfly share the same strike price, we cannot set our Credit Call and Credit Put Spread apart, but we can still adjust the width of our spreads (or the ‘wings’). In addition, an investor with a somewhat bullish bias might choose to set the short options (or ‘guts’) of the Iron Butterfly to an upside price target, while the somewhat bearish investor may choose to do the opposite.
So, we decide to open the 370/383/383/396 Iron Condor at $9.85, collecting $985 in premium.
This visual setup using the Options AI platform shows our profit zone (dark green) – the zone we need the stock to stay within at expiration in order to keep some of the premium received.
It is important to notice the absence of a zone of Max. Gain (light green). Instead, the Iron Butterfly has a precise point of hypothetical maximum gain (the short Call & Put strike). Therefore, keeping our entire premium collected and maximizing profit is an unlikely outcome when using this strategy. For this to occur, it would mean the underlying stock closing precisely at the short strike price at expiration and for neither short option contract to be assigned. It follows therefore, that when using an Iron Butterfly we are typically hoping for a degree of profitability, rather than a more binary outcome.
Also noticeable is the relatively low risk to reward ratio (compared to other vertical credit spreads) as well as a probability of profit in excess of 50%. We will look at this in more detail in the summary below.
In this Iron Butterfly example we have a defined Max Risk of $315. That’s the most that we can lose if the stock closes above our long 396 Call strike or below our long 370 Put strike at expiration. We will see gains if the stock stays within our breakeven levels of 392.85 and 373.15 and a Max Gain of $985 if the stock trades precisely at our short 383 strike at expiration and neither our short Call or short Put are assigned (highly unlikely).
What may become apparent from this visualization and associated metrics is why the Iron Butterfly is a favored strategy of income seeking investors with highly convicted neutral stock view and/or a view that option prices are currently overstating any potential move.
One key point to note is the Iron Butterfly can often both incur elevated early assignment risk (since we will typically have an in-the-money short leg) and require more active trade management. Given that there is no zone of maximum profit, where all options can expire out-the-money and worthless, if the Iron Butterfly is not closed prior to expiration it will typically either a] expire at Max Loss if both legs of either the Call or Put spread are in-the-money; or b] require closing on the day of expiration to avoid assignment on just one leg. This further emphasizes the fact that an investor using an Iron Condor is not typically expecting to keep all of the income received when opening the position.