What is an Iron Butterfly Option Strategy?

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You can think of this strategy as simultaneously running a short put spread and a option trading iron butterfly call spread with the spreads converging at strike B. Ideally, you want all of the options in this spread to expire worthless, with the stock at strike B. It is possible to put a directional bias on this trade. If strike B is higher than the stock price, this would be considered a bullish trade. If strike B is below the stock price, it would be a bearish trade.

That causes some investors to opt for the long butterfly instead. Some investors may wish to run this strategy using index options rather than options on individual stocks.

Strike prices are equidistant, and all options have the same expiration month. Typically, investors will use butterfly spreads when anticipating minimal movement on the stock within a specific time frame.

You want the stock price to be exactly at strike B at expiration so all four options expire worthless. Risk option trading iron butterfly limited to strike B minus strike A, minus the net credit received when establishing the position.

Margin requirement is the short call spread requirement or short put spread requirement whichever is greater. The net credit received from establishing the iron butterfly may be applied to the initial margin requirement. Keep in mind this requirement is on a per-unit basis.

For this strategy, time decay is your friend. Ideally, you want all of the options in this spread to expire worthless with the stock precisely at strike B. After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices. If your forecast was correct and the stock price is at or around strike B, you want volatility to decrease.

Your main concern is the two options you sold at strike B. A decrease in implied volatility will cause those near-the-money options to decrease in value. So the overall value of the butterfly will decrease, making it less expensive to close your position. In addition, you want the stock price to remain stable around strike B, and a decrease in implied volatility suggests that may be the case.

If your forecast was incorrect and the stock price is below strike A or above strike C, in general you want volatility to increase. This is especially true as expiration approaches. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike B. So the overall value of the iron butterfly will decrease, making it less expensive to close your position.

Options involve risk and are not option trading iron butterfly for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.

Multiple leg options strategies involve additional risksand may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability option trading iron butterfly reaching a specific price point. The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option trading iron butterfly contract.

There is no guarantee that the forecasts of implied volatility or the Greeks will be correct. Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. System response and access times may vary due to market conditions, system performance, and other factors.

Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a option trading iron butterfly or solicitation to buy or sell a particular security or to engage in any particular investment strategy.

The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results. All investments involve risk, option trading iron butterfly may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns.

The Options Playbook Featuring 40 options strategies for bulls, bears, rookies, all-stars and everyone in between. The Strategy You can think of this strategy as simultaneously running a short put spread and a short call spread with the spreads converging at strike B. When to Run It Typically, investors will use butterfly spreads option trading iron butterfly anticipating minimal movement on the stock within a specific time frame. Break-even at Expiration There are two break-even option trading iron butterfly for this play: Strike B plus net credit received.

Strike B minus net credit received. The Sweet Spot You want the stock price to be exactly at strike B at expiration so all four options expire worthless. Maximum Potential Profit Option trading iron butterfly profit is limited to the net credit received. Maximum Potential Loss Risk is limited to strike B minus strike A, minus the net credit received when option trading iron butterfly the position. Ally Invest Margin Requirement Margin requirement is the short call spread requirement or short put spread requirement whichever is greater.

As Time Goes By For this strategy, time decay is your friend. Implied Volatility After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.

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Important legal information about the email you will be sending. By using this service, you agree to input your real email address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an email.

All information you provide will be used by Fidelity solely for the purpose of sending the email on your behalf. The subject line of the email you send will be "Fidelity. To profit from a stock price move up or down beyond the highest or lowest strike prices of the position.

A long iron butterfly spread is a four-part strategy consisting of a bear put spread and a bull call spread in which the long put and long call have the same strike price. All options have the same expiration date, and the three strike prices are equidistant. In the example above, one 95 Put is sold, one put is purchased, one Call is purchased and one Call is sold. This strategy is established for a net debit, and both the potential profit and maximum risk are limited.

The maximum profit is the difference between the lower and center strike prices less the net debit paid. The maximum profit is realized if the stock price is above the highest strike price or below the lowest strike price at expiration. The maximum risk is the net cost of the position including commissions, and the maximum risk is realized if the stock price is equal to the strike price of the long options center strike on the expiration date.

Given that there are four options and three strike prices, there are multiple commissions in addition to four bid-ask spreads when opening the position and again when closing it. The maximum profit potential is equal to the difference between the lowest or highest and middle strike prices less the net debit paid including commissions.

In the example above, the difference between the lowest and middle strike prices is 5. The maximum profit potential, therefore, is 1. There are two possible outcomes in which the maximum profit is realized. If the stock price is below the lowest strike price at expiration, then the calls expire worthless, but both puts are in the money. With both puts in the money, the bear put spread reaches its maximum value and maximum profit. Also, if the stock price is above the highest strike price at expiration, then the puts expire worthless, but both calls are in the money.

Consequently, the bull call spread reaches it maximum value and maximum profit. The maximum risk is equal to the net debit paid plus commissions, and a loss of this amount is realized if the stock price is equal to the strike price of the long options center strike at expiration. In this outcome, all options expire worthless and the net debit plus commissions is lost. There are two breakeven points. The lower breakeven point is the stock price equal to the center strike price minus the net debit paid.

The upper breakeven point is the stock price equal to the center strike price plus the net debit paid. A long iron butterfly spread realizes its maximum profit if the stock price is above the highest strike or below the lowest strike on the expiration date.

A long iron butterfly spread is the strategy of choice when the forecast is for a stock price move outside the range of the highest and lowest strike prices. Unlike a long straddle, however, the profit potential of a long iron butterfly spread is limited. Also, the commissions for a butterfly spread are higher than for a straddle.

The tradeoff is that a long iron butterfly spread has breakeven points much closer to the current stock price than a comparable long straddle or long strangle. Long iron butterfly spreads are sensitive to changes in volatility see Impact of Change in Volatility.

The net debit paid for a long iron butterfly spread rises when volatility rises and falls when volatility falls. Consequently some traders establish long iron butterfly spreads when they forecast that volatility will rise.

Since the volatility in option prices tends to rise in the weeks leading up to an earnings reports, some traders will open a long iron butterfly spread two to three weeks before an earnings report and close the position immediately before the report.

Success of this approach to trading long iron butterfly spreads requires that the stock price rise above the highest strike price or fall below the lowest strike or that volatility rises. If the stock price does not move, or if volatility falls, then a loss will be incurred. If volatility is constant, long iron butterfly spreads do not show much of a loss until it is very close to expiration and the stock price is close to the center strike price.

In contrast, long straddles suffer much more from time erosion and begin to show losses early in the expiration cycle as long as the stock price does not move beyond the breakeven points. Therefore, if the stock price remains near the center strike price as expiration approaches, a trader must be ready to close out the position before a large percentage loss is incurred.

Patience and trading discipline are required when trading long iron butterfly spreads. Patience is required because this strategy profits from trending stock price movement outside the range of strike prices, and stock price action can be unsettling as it rises and falls around the highest or lowest strike price as expiration approaches. Long calls have positive deltas, short calls have negative deltas, long puts have negative deltas, and short puts have positive deltas.

Regardless of time to expiration and regardless of stock price, the net delta of a long iron butterfly spread remains close to zero until one or two days before expiration. If the stock price is below the lowest strike price in a long iron butterfly spread, then the net delta is slightly negative. If the stock price is above the highest strike price, then the net delta is slightly positive. Overall, a long iron butterfly spread profits from a stock price move outside the range of strike prices.

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Long options, therefore, rise in price and make money when volatility rises, and short options rise in price and lose money when volatility rises.

When volatility falls, the opposite happens; long options lose money and short options make money. Long iron butterfly spreads have a positive vega. This means that the net debit for establishing a long iron butterfly spread rises when volatility rises and the spread profits money. When volatility falls, the net debit falls and the spread loses money.

This is known as time erosion. Long option positions have negative theta, which means they lose money from time erosion, if other factors remain constant; and short options have positive theta, which means they make money from time erosion.

A long iron butterfly spread has a net negative theta as long as the stock price is in a range between the lowest and highest strike prices. Consequently, a long iron butterfly spread loses money from time erosion if the stock price stays inside the range of strike prices. However, if the stock price moves outside the range of strike prices, the theta becomes positive and the position profits as expiration approaches.

Stock options in the United States can be exercised on any business day, and holders of short stock option positions have no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long options in an iron butterfly spread have no risk of early assignment, the short options do have such risk. Early assignment of stock options is generally related to dividends.

Short calls that are assigned early are generally assigned on the day before the ex-dividend date, and short puts that are assigned early are generally assigned on the ex-dividend date.

In-the-money calls and puts whose time value is less than the dividend have a high likelihood of being assigned. If the short call in a long iron butterfly spread is assigned, then shares of stock are sold short and the long call and both puts remain open. If a short stock position is not wanted, it can be closed in one of two ways. First, shares can be purchased in the marketplace. Second, the short share position can be closed by exercising the long call.

Although exercising a long call forfeits its time value, in the case of a long iron butterfly spread, exercising the long call is generally preferred. Since the long call in this strategy has a lower strike price than the short call, it must have less time value than the short call.

Buying shares to cover the short stock position and then selling the long call is only advantageous if the commissions are less than the time value of the long call.

Note, however, that whichever method is used, buying stock and sell the long call or exercising the long call, the date of the stock purchase will be one day later than the date of the short sale. This difference will result in additional fees, including interest charges and commissions.

Assignment of a short option might also trigger a margin call if there is not sufficient account equity to support the stock position created. If the short put is assigned, then shares of stock are purchased and the long put and both calls remain open. If a long stock position is not wanted, it can be closed in one of two ways.

First, shares can be sold in the marketplace. Second, the long share position can be closed by exercising the long put. Again, although exercising a long put forfeits its time value, in the case of a long iron butterfly spread, exercising the long put is generally preferred. Since the long put in this strategy has a higher strike price than the short put, it must have less time value than the short put.

Selling shares to close the long stock position and then selling the long put is only advantageous if the commissions are less than the time value of the long put. Note, again, that whichever method is used, selling stock or exercising a long put, the date of the stock sale will be one day later than the date of the purchase.

The position at expiration of a long iron butterfly spread depends on the relationship of the stock price to the strike prices of the spread. If the stock price is below the lowest strike price, then both puts are in the money and both calls are out-of-the-money.

In this case both calls expire worthless, but the short put lowest strike is assigned and the long put center strike is exercised. As a result, stock is purchased at the lowest strike and sold at the center strike, so the maximum profit is earned, but no stock position is created.

If the stock price is above the lowest strike and at or below the center strike, then the short put lowest strike and both calls expire worthless, but the long put is exercised. The result is that shares of stock are sold short and a stock position of short shares is created. If the stock price is above the center strike and at or below the highest strike, then the short call highest strike and both puts expire worthless, but the long call is exercised.

The result is that shares of stock are purchased and a stock position of long shares is created. If the stock price is above the highest strike, then both calls are in the money and both puts are out-of-the-money. In this case both puts expire worthless, but the long call center strike is exercised and the short call highest strike is assigned.

As a result, stock is purchased at the center strike and sold at the highest strike, so the maximum profit is earned, but no stock position is created.

This strategy is labeled "Long Iron Butterfly". On the other hand, some traders refer to this strategy as "Short Iron Butterfly," because its profit and loss diagram looks like the diagrams of a short butterfly spread with calls and a short butterfly spread with puts. Since even experienced traders frequently disagree on how to describe the opening and closing of this strategy, all traders who use this strategy should be careful to communicate exactly and clearly the position that is being opened or closed.

Short iron butterfly spread.