How Do Iron Butterfly Options Trades Work? - SmartAsset

The iron butterfly options trading strategy aims to profit investors during periods of low volatility. Also known as the “short iron butterfly” or the “iron fly,” the strategy makes its money off price stability. As an investor, you open several different contracts. Your profit comes from keeping the premiums on your contracts so long as the market doesn’t move. You also hedge your risk with a few long positions in case the market does move. On the other hand, you risk a loss if prices start to move significantly in either direction. Here’s how it works. A financial advisor can show you several ways of profiting from low-volatility situations.

What Is an Iron Butterfly

An iron butterfly strategy is built out of four options contracts in total. Your profit comes from the premiums made by selling a pair of options (short positions), while you hedge your risks by purchasing another pair of contracts (long positions).

Put/Call – A put option is one in which the holder has the right but not the obligation to sell the underlying asset for a certain price on a specific date. A call option is one in which the holder has the right but not the obligation to buy the underlying asset for a certain price on a specific date.
Long/Short – A long position in an options contract means that you bought the contract and hold the rights that this contract gives. A long call means you can sell the asset, and a long put means that you can buy it. A short position means that you sold the contract and must honor the rights of whoever holds it. A short call means that you have to buy the asset from whoever holds the contract should they exercise their option, a short-put means that you must sell the asset.

An iron butterfly is a bet against volatility. It profits off market stability and maximizes profits if the underlying asset has a $0.00 price change. To build an iron butterfly you enter four simultaneous options contracts. All four are built on the same underlying asset (typically a stock) and have the same expiration date.

Long-Call: Buy a call contract with a strike price above the current asset.
Long-Put: Buy a put contract with a strike price below the current asset.

These are the outer boundaries of your position. As will be explained below, they control the risk of your position.

Short-Call: Sell a call contract with a strike price at the asset’s current price.
Short-Put: Sell a put contract with a strike price at the asset’s current price.

These prices establish your profit potential on this strategy. Note that a standard iron butterfly sets your short positions at the asset’s current price. However, you can set a bullish iron butterfly, in which your short positions share a strike price above the asset’s current price, or a bearish iron butterfly, in which your short positions share a strike price below the asset’s current price. The only requirement is that your short positions share the same strike price.

You would enter a bearish iron butterfly if you expect the asset’s price to decline and then stabilize. A bullish iron butterfly is useful if you expect growth before stability.

It is also standard for your long positions to mirror each other. For example, if your long call is set $10 above the asset’s current strike price, it is standard for your long put to be set $10 below the asset’s current strike price. However, this is not necessary.

Finally, readers will note that this structure is very similar to the iron condor. These two strategies are in most respects identical. The difference is that in an iron condor your short positions have different strike prices while in the iron butterfly, your short positions share an identical strike price. This makes the iron butterfly potentially more profitable than the iron condor, as its short position premiums will be higher, but also riskier, as the iron condor has some room for price movement before a short position goes in the money.

Example of an Iron Butterfly

Let’s say you want to open an iron butterfly on XYZ Corp. Its stock is currently selling for $50 per share. You might open the following four contracts:

Long-Call for $60, Expiration January 1
Long-Put for $40, Expiration January 1
Short-Call for $50, Expiration January 1
Short-Put for $50, Expiration January 1

Note that you have entered a standard iron butterfly. It is neither bullish nor bearish, as your strike price is set at XYZ Corp.’s current price, and your long positions mirror each other.

How Does an Iron Butterfly Work?

An iron butterfly profits off stability. The more volatile the market, in any direction, the more likely it is that you will lose money. Your profits from an iron butterfly come from the premiums you make by selling the short positions. Since those short positions are priced at the money, both have a high chance of closing in the money. (It’s unlikely that your asset won’t move at all, the question is just in which direction.) This makes the premiums you can charge also relatively high.

These profits are partially offset by the premiums you pay to buy the long positions. Since your long positions have strike prices set further from the asset’s current price, they’re less likely to close profitably. This means that the premiums you pay to buy these contracts will be lower than the premiums you collect selling the short positions.

This relationship is the heart of the iron butterfly. Your profits are the amount that you collect selling your short positions. The premiums you spend buying your long positions reduce these profits somewhat but cap the total risk that you’ve taken.

For example, our sample iron butterfly might look like this: XYZ Corp., currently priced at $50 per share.

Long-Call for $60, Expiration January 1, Premium $1
Long-Put for $40, Expiration January 1, Premium $1
Short-Call for $50, Expiration January 1, Premium $3
Short-Put for $50, Expiration January 1, Premium $3

With a standard 100 shares per option contract, our opening position would be:

Premiums collected: ($3 x 100) + ($3 x 100) = $600
Premiums spent: ($1 x 100) + ($1 x 100) = $200
Total: Starting profit of $400

Once you have opened this position your risk is defined by how far the asset’s price moves from its starting position. (Or, if you have entered a bullish/bearish iron butterfly, how far the asset’s price closes from your short contract strike price.)

Because you have sold these short contracts, you are obligated to honor them and will lose money as the asset’s price changes. If the asset’s price rises, you will be obligated to honor the call contract that you wrote and will lose money on it. The same will be true of the put contract if the asset’s price falls.

At a certain point, called your breakeven point, your losses on the short position exceed the premiums that you collected. However, this risk is hedged by the long position that you opened. If the asset’s price rises past the strike price of your long call, you make $1 for every $1 you lose on the short call, offsetting those losses and capping your risk. Again, the same is true of your long/short put contracts if the asset’s price falls.

Ultimately an iron butterfly position is defined by two basic rules:

Maximum profit is defined by the premiums collected from your short positions, less the premiums spent buying your long positions. You will make the most money if the asset’s price doesn’t change at all.
The maximum risk of an iron butterfly is defined as the difference between your short position strike price and your long call strike price or your long put strike price, whichever is greater; multiplied by the number of contracts you sold; reduced by the premiums you collected on your short positions.

The further out you set your long position strike prices, the greater your initial profits because the premiums on these contracts will be lower. However, you will also undertake greater risk, because in a volatile market those higher strike prices mean you can potentially lose more money before your hedges kick in.

An Iron Butterfly in Practice

To understand this fully, let’s revisit our iron butterfly example from above. As a reminder, this is an iron butterfly for XYZ Corp., currently priced at $50 per share, 100 shares per contract.

Long-Call for $60, Expiration January 1, Premium $1
Long-Put for $40, Expiration January 1, Premium $1
Short-Call for $50, Expiration January 1, Premium $3
Short-Put for $50, Expiration January 1, Premium $3
Total starting profit of $400

If XYZ Corp. stays at exactly $50 we will make $400 off this position. However, that’s unlikely. The stock price will move at least somewhat; our bet is that XYZ Corp. will remain relatively stable and close to its starting price. From our formula above, we know that our maximum risk in this position is:

Difference between the long strikes and short strikes: $10 ($60 – $50 or $50 – $40)
$10 x 100 shares = $1,000
$1,000 – $400 = $700

This position can lose up to $700 before the long positions kick in and begin to earn you $1 for every $1 you lose to your short contracts.

For example, say on January 1 XYZ Corp. has remained low-volatility and gone up only to $51 per share. Your position would look like this:

Long-Call for $60, Expires out of the money
Long-Put for $40, Expires out of the money
Short-Call for $50, Expires in the money at $1 per share
Short-Put for $50, Expires in the money

To honor your short call, you must sell the holder 100 shares of XYZ Corp. at $50 per share for a net loss of $1 per share. This makes your net profit/loss:

Short-Call: $1 loss per share at 100 shares
$1 x 100 = $100 loss
$300 Premium Gains – $100 Loss = $200

You have made $200 when all of these contracts expire.

However, let’s say that XYZ Corp. has greater volatility than expected and drops to $35 per share by January 1. Your position would look like this:

Long-Call for $60, Expires out of the money
Long-Put for $40, Expires in the money at $5 per share
Short-Call for $50, Expires out of the money
Short-Put for $50, Expires in the money at $15 per share

To honor your short put, you must buy 100 shares of XYZ Corp. from the holder at $50 per share for a net loss of $15 per share. But your long put gives you the right to buy 100 shares of XYZ Corp. at $40 per share, for a net gain of $5 per share. Your position would then look like this:

Short-Put: $15 loss per share at 100 shares = $1,500 loss
Long-Put: $5 gain per share at 100 shares = $500 gain
$1,500 Loss – $500 Gain – $300 Premium Gains = $700

As you can see, this contract has lost its maximum amount. However, it can’t lose more. For every additional dollar that XYZ Corp. falls your short put position will lose another $1 per share, but your long put position will gain you another $1 per shares. These positions offset each other in the same way that your long positions would if the price rose.

The Bottom Line

Two female investors considering the iron butterfly

The iron butterfly is a credit spread that uses options contracts to generate a revenue stream. It’s effective during times of low price volatility. The strategy limits risk but also caps profits. You make money by selling contracts and keeping the premiums so long as the market doesn’t move, and hedge your risks with a few long positions just in case it does. The iron butterfly is one of the more complex maneuvers and many brokerages require investors to demonstrate a skill level and adequate financial resources before they can undertake an iron butterfly.

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