Long Iron Butterfly Option Strategy

A long iron butterfly is an advanced options strategy that combines elements of a long straddle and a short strangle to create a position where the investor profits from minimal price movement in the underlying asset. This strategy involves holding a call option and a put option at the same strike price, along with selling two options of the same type (either both calls or both puts) with a higher and lower strike price, respectively. The strategy benefits from limited risk while maximizing the potential for a small price movement near the strike price of the options.

Introduction

The long iron butterfly strategy is typically used when the investor believes that the underlying asset’s price will remain within a narrow range at expiration. This strategy has a limited risk profile and is profitable if the underlying asset’s price stays close to the strike price of the options. The iron butterfly is a neutral strategy that benefits from time decay and low volatility.

This strategy involves four legs:

  • Long call at the at-the-money (ATM) strike price

  • Long put at the ATM strike price

  • Short call at a higher strike price

  • Short put at a lower strike price

The long call and long put form a straddle, while the short call and short put form a short strangle. The position is established with a net debit, meaning the investor pays a premium to enter the trade.

What is a Long Iron Butterfly?

A long iron butterfly is a four-legged options strategy that involves buying an out-of-the-money call and put option at the same strike price (known as the body of the butterfly), while simultaneously selling a call option with a higher strike price and a put option with a lower strike price (the wings of the butterfly). The maximum potential profit is achieved when the underlying asset's price is equal to the strike price of the options at expiration.

For example:

  • Buy 1 XYZ (Month 1) 100 call

  • Buy 1 XYZ (Month 1) 100 put

  • Sell 1 XYZ (Month 1) 110 call

  • Sell 1 XYZ (Month 1) 90 put

In this example, the investor is entering into a long iron butterfly with a $100 strike price for both the long call and long put, and the short call and short put are at $110 and $90, respectively.

Additional Considerations

The long iron butterfly strategy is designed to profit when the underlying asset's price remains close to the strike price of the body options at expiration. The maximum profit occurs when the asset's price is at or near the body strike price, causing the short options to expire worthless and the long options to have maximum intrinsic value.

Since the strategy involves buying both a call and a put at the same strike price (the body of the butterfly), it has similarities to a long straddle but with a more limited risk/reward profile. By selling the out-of-the-money call and put (the wings), the investor receives premium that offsets some of the costs of the long options, reducing the overall cost of the position.

The primary risk of the long iron butterfly is limited to the net premium paid to establish the position. However, it is important to note that this strategy requires the underlying asset to stay within a narrow range for the maximum profit to be realized. A significant move in either direction will result in a loss.

Example Scenario

Consider stock XYZ, which is currently trading at $100. The investor believes the stock will trade within a narrow range but is unsure of the exact direction. The investor decides to enter a long iron butterfly strategy, buying and selling options at various strike prices.

  1. Buy 1 XYZ (Month 1) 100 call for $4.00 (total premium paid = $400)

  2. Buy 1 XYZ (Month 1) 100 put for $4.00 (total premium paid = $400)

  3. Sell 1 XYZ (Month 1) 110 call for $2.00 (total premium received = $200)

  4. Sell 1 XYZ (Month 1) 90 put for $2.00 (total premium received = $200)

In this case, the total premium paid for the position is $400 (call) + $400 (put) = $800. The total premium received for the short options is $200 (call) + $200 (put) = $400. Therefore, the total net debit to establish the position is $800 – $400 = $400 (not including commissions and fees).

Profit and Loss Analysis

Maximum Profit:

The maximum profit of the long iron butterfly is realized if the underlying asset's price is at or near the strike price of the long call and long put at expiration (the body of the butterfly). In this case, the maximum profit occurs if the price of stock XYZ is exactly $100 at expiration. At this point, the long call and long put will have intrinsic value, and the short options will expire worthless.

  • Max Profit = Difference between the strike prices of the wings – Total Net Premium Paid
    In this example:
    = ($110 – $90) – $400
    = $1,000 – $400
    = $600 (not including commissions and fees)

Maximum Loss:

The maximum loss occurs if the underlying asset's price moves significantly away from the body strike price and both the long options expire worthless. The loss is limited to the net premium paid for the position, which is the cost of the long call and long put minus the premiums received from the short options.

  • Max Loss = Total Net Premium Paid
    In the example above:
    = $400 (not including commissions and fees)

Breakeven Points:

There are two breakeven points for a long iron butterfly, one on the upside and one on the downside. The breakeven points are calculated by adding and subtracting the total net premium paid from the body strike price.

  • Upper Breakeven = Strike Price of Call (Body) + Total Net Premium Paid
    = $100 + $4.00
    = $104.00

  • Lower Breakeven = Strike Price of Put (Body) – Total Net Premium Paid
    = $100 – $4.00
    = $96.00

For the strategy to be profitable, the price of the underlying asset must remain within the range of $96.00 to $104.00 at expiration.

At-A-Glance Summary

Strategy: Long Iron Butterfly
Alternative Name: Iron Butterfly
Pre-Requisite Strategy Knowledge: Long Call, Long Put, Short Call, Short Put
Legs of Trade: 4 legs
Sentiment: Neutral (price range-bound)
Example:

  • Buy 1 XYZ (Month 1) 100 call

  • Buy 1 XYZ (Month 1) 100 put

  • Sell 1 XYZ (Month 1) 110 call

  • Sell 1 XYZ (Month 1) 90 put
    Max Potential Profit (Gain): Difference between the strike prices of the wings – total net premium paid
    Max Potential Risk (Loss): Total Net Premium Paid
    Breakeven Points:

  • Upper Breakeven: Strike Price of Call (Body) + Total Net Premium Paid

  • Lower Breakeven: Strike Price of Put (Body) – Total Net Premium Paid
    Ideal Outcome: Underlying asset’s price remains at or near the body strike price (at expiration)
    Early Assignment Risk: Early assignment risk applies only to the short options (call and put). If one of the short options is exercised, the trader may be required to take action, such as buying back the short option or adjusting the position.

Risks and Risk Mitigation

The primary risk of the long iron butterfly strategy is the limited profit potential if the underlying asset moves away from the body strike price. This strategy has a higher probability of profit than more directional strategies but requires precise timing and price movement within a specific range.

To mitigate risk, it is essential for the investor to monitor the position carefully, especially as expiration approaches. If the price of the underlying asset is not moving within the desired range, the investor might consider adjusting or closing the position to limit losses. This could involve rolling the short options or closing the entire position early to cut losses.