Short Iron Butterfly Option Strategy

The short iron butterfly is a more advanced and aggressive options strategy typically used by traders who expect a significant movement in the price of an underlying asset, and thus seek to profit from increased volatility. In contrast to the long iron butterfly, which profits from low volatility and a range-bound market, the short iron butterfly is employed when the investor believes the price of the underlying asset will move away from the central strike price—either rising or falling significantly. This strategy involves selling a combination of options at three distinct strike prices, with the goal of capitalizing on the possibility of large price swings.

Introduction

A short iron butterfly involves four positions:

  • A short call at the middle strike price

  • A long call at a higher strike price

  • A short put at the middle strike price

  • A long put at a lower strike price

This setup is generally executed using options with the same expiration date. The short call and short put are at the same middle strike price, while the long call and long put are located at different strike prices, further from the underlying asset's current market price.

The short iron butterfly is considered a non-directional strategy with high potential rewards and significant risk if the market moves substantially in either direction.

What is a Short Iron Butterfly?

In the short iron butterfly, the trader combines elements of a short straddle and a long iron condor. The position profits from large price movements in the underlying asset, as opposed to the long iron butterfly, which benefits from low volatility.

A typical short iron butterfly setup consists of:

  1. Sell 1 call at the middle strike price (e.g., 100 strike)

  2. Buy 1 call at a higher strike price (e.g., 110 strike)

  3. Sell 1 put at the middle strike price (e.g., 100 strike)

  4. Buy 1 put at a lower strike price (e.g., 90 strike)

In this case, the short options (both the call and put at the middle strike) generate premium income, while the long call and put (further out-of-the-money options) limit potential losses in case the price moves significantly beyond the middle strike.

The main advantage of the short iron butterfly is its potential for large profits when the price of the underlying asset makes a significant move either up or down. This strategy is often used by traders expecting high volatility or during earnings season, when large price moves are more likely.

Example Scenario

Consider a stock XYZ, trading at $100. A trader may set up a short iron butterfly with the following options:

  1. Sell 1 XYZ 100 call for $3.00

  2. Buy 1 XYZ 110 call for $1.00

  3. Sell 1 XYZ 100 put for $2.50

  4. Buy 1 XYZ 90 put for $1.00

Here:

  • The trader sells a call and put at the 100 strike price.

  • The trader buys a call at the 110 strike price and a put at the 90 strike price.

The total net credit received for entering the position is:

  • Total premium received from the short call and short put: $3.00 (call) + $2.50 (put) = $5.50

  • Total premium paid for the long call and long put: $1.00 (call) + $1.00 (put) = $2.00

  • Net premium received: $5.50 – $2.00 = $3.50

This $3.50 represents the maximum potential profit the trader can make from this trade.

Profit and Loss Analysis

Maximum Profit:

The maximum profit in a short iron butterfly is the net premium received when the price of the underlying asset moves significantly away from the middle strike price (in either direction). This profit is earned when the price of the underlying asset moves far enough away from the middle strike price such that the long options (call and put) offset any potential losses from the short options, while the short options expire worthless. The maximum profit occurs if the underlying asset’s price moves far enough beyond the outer strike prices (either below 90 or above 110).

  • Max Profit = Net Premium Received
    In this case:
    = $3.50 (not including commissions and fees)

Maximum Loss:

The maximum loss occurs if the price of the underlying asset remains at or near the middle strike price (in this case, $100) at expiration. If the price remains at $100, both the short call and short put will expire worthless, and the trader will be left with the premium paid for the long call and put positions. The maximum loss is capped by the cost of the long options minus the premium received from the short options.

  • Max Loss = Difference between the middle strike price and either long strike price – Net Premium Received
    In this case:
    = ($110 – $100) or ($100 – $90) – $3.50
    = $10.00 – $3.50
    = $6.50 (not including commissions and fees)

Breakeven Points:

The breakeven points occur when the price of the underlying asset equals the strike prices of the short options plus and minus the net premium received.

  • Upper Breakeven = Middle Strike Price + Net Premium Received
    = $100 + $3.50
    = $103.50

  • Lower Breakeven = Middle Strike Price – Net Premium Received
    = $100 – $3.50
    = $96.50

The underlying asset needs to move above $103.50 or below $96.50 for the position to be profitable. If the price stays between these two points, the position will result in a loss.

At-A-Glance Summary

Strategy: Short Iron Butterfly
Alternative Name: Iron Butterfly
Pre-Requisite Strategy Knowledge: Short Straddle, Long Iron Condor
Legs of Trade: 4 legs
Sentiment: Neutral-to-Bullish/Bearish (Expecting large price movement)
Example:

  • Sell 1 XYZ 100 call

  • Buy 1 XYZ 110 call

  • Sell 1 XYZ 100 put

  • Buy 1 XYZ 90 put
    Max Potential Profit (Gain): Net Premium Received
    Max Potential Risk (Loss): Difference between the middle strike price and either of the long strike prices – Net Premium Received
    Breakeven Points:

  • Upper Breakeven: Middle Strike Price + Net Premium Received

  • Lower Breakeven: Middle Strike Price – Net Premium Received
    Ideal Outcome: Underlying asset’s price moves significantly away from the middle strike price (either up or down) at expiration
    Early Assignment Risk: Early assignment risk applies to the short options (call and put). If one of the short options is exercised early, the trader may need to adjust or close the position to avoid significant losses.

Risks and Risk Mitigation

The primary risk of the short iron butterfly is the possibility that the underlying asset's price stays near the middle strike price, leading to a maximum loss. If the price moves within the range defined by the long options, the short options will expire worthless, but the trader will still lose the premium paid for the long options.

To mitigate risk, traders should monitor the underlying asset's price movement closely and consider exiting the position if the price begins to move in an undesirable direction. Additionally, traders should be prepared to adjust the position or close it early if the price remains at the middle strike price.

The short iron butterfly is a high-risk strategy with the potential for high reward. However, it requires careful monitoring and the ability to quickly adjust or close the position in response to market movements. Traders using this strategy should have a solid understanding of market volatility and the risks associated with options trading.