What are Iron Butterfly Options?
How does this investment strategy work?
What are the essential elements you should know!
In this article, we will break down the notion of Iron Butterfly Options so you know all there is to know about it!
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What Are Iron Butterfly Options
Iron butterfly options, also referred to as “Iron Fly”, refers to a trade strategy where four different contracts are used to earn profits from stock and futures price movements in the market within a certain period of time.
The objective of such options trade set up is to earn profits from a decline in implied volatility.
The way it works is that a stock trader will identify a stock and attempt to predict the price of that stock in the near future, say two weeks in the future.
Then, the trader will transact four options contracts as follows:
- Purchase one call option with a strike price well above the forecasted stock price (left wing)
- Sell a call option with a strike price the same as the estimated future stock price (center)
- Sell a put option with a strike price the same as the estimated future stock price (center)
- Purchase one put option with a strike price well below the forecasted stock price (right wing)
All these options will have the same expiration date (two weeks in our example here).
In two weeks, the trader hopes that the stock price will land on the estimated target price.
If the stock price ends up hitting the target price in two weeks, the trader gets to keep the premiums received for selling to put and call options.
However, if the stock price moves away from the center, the trader’s profit will diminish and the maximum loss will be felt if the stock price goes above the call option strike price (left wing) or below the put option strike price (right wing)
How Does It Work
The Iron butterfly options strategy is composed of:
- Two call options
- Two put options
The call options and put options will be selected in such a way that they provide three different strike prices and all with the same expiration date.
The way a trader earns the most profit is when the underlying stock ends up close to the “middle” strike price around the time all four options are about to expire.
This investment strategy allows an investor, trader, portfolio manager, or investment manager to earn some profits with a limited upside potential.
The reason why the upside is limited is that the trader’s objective is to earn some money by selling two options and hoping they become worthless and the options holders do not exercise them by the expiration of the options contract.
If the options are not exercised, the investor will keep the credits obtained by selling the options contracts.
On the other hand, the risk assumed by the investor will also be defined.
In other words, the two option contracts that are purchased, also referred to as the “wings”, help protect the trader from significant upward or downward movement in the underlying stock price.
Iron Butterfly Option Strategy Steps
Here are the steps to follow to structure an iron fly option strategy.
The first step is to identify an underlying asset or stock.
Then, you must forecast what the stock price will be at a specific point in time in the future and this will be your “target price”.
With the fly options strategy, your objective is to structure your option contracts in such a way that you earn maximum profit if the underlying stock ends up achieving your target price in the future.
Then, you must purchase one call option with a strike price largely above your target price where you’d expect this call option to be out-of-the-money at its expiration date.
Should the underlying stock price go up during the options contract period, this call option will help protect against losses.
At the same time as buying one call option, you must sell one call option and one put option where you aim to have a strike price close to your target price at their expiration.
The last step is to buy one put option with a strike price largely below your target price.
Similarly, you’d expect that this put option would be out-of-the-money when the options expire and will protect you against a significant drop in the underlying stock price.
By keeping a good spread in the strike price between the call option and put options sold, you can expect to benefit from a larger range of price volatility in the underlying asset to earn a profit.
Iron Butterfly Options Example
Let’s assume that a stock is currently worth $80 per share.
If you expect for the stock price go up to $100 in the next two weeks with a maximum range of $110 and a lower range of $90, you can structure your Iron Fly as follows:
- Buy a call option at $110
- Buy a put option at $90
- Sell a call option at $100
- Sell a put option at $100
If at the expiration of the options contract, the stock finishes at the center of the butterfly, then you’ll earn the highest profits by keeping the premium received for selling the two options.
The more the stock price moves away from the center to either wing, the investor’s anticipated profits will diminish.
The maximum loss will be experienced when the underlying stock exceeds the call option value or falls below the put option value on the wings.
Options Iron Butterfly Takeaways
So what is the financial definition of Iron Butterfly Options?
Let’s look at a summary of our findings.
Iron Fly Options
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