Iron Butterfly and its Strategies Explained
Options trading is an interesting thing for investors in the share markets. The reason is, there are different trading strategies available that are exclusive to options trading. Amongst the different strategies out there, the iron butterfly strategy is unique.
However, a trader needs to be a pro in investing to pull this off. The iron butterfly option strategy needs a lot of effort to comprehend. That being said, if you can get your basics right, it will not be any problem for you to get acquainted with and execute this particular options strategy. But before everything else, understand the same patiently.
So, let’s dive straight into the real meaning of the iron butterfly strategy in trading.
Iron Butterfly in Options Strategy – It’s Meaning
To put it simply, the iron butterfly strategy uses both put options and call options while trading. It revolves around the four options, with each having the same dates of expiration.
For executing the iron butterfly strategy, you need to execute the following four trades:
- Buy a put option at strike value A
- Sell a put option at strike value B
- Sell a call option at strike value B
- Buy a call option at strike value C
All the three different strike values mentioned above are equidistant. They are also in order of increasing values; A, B, and C. For example, the strike values above could be ₹100, ₹200, and ₹300, respectively. Now, the iron butterfly strategy here will involve a bullish put spread and a bearish call spread. Let’s understand this better with an example.
Also Read: What is a Bear Put Spread in Options Trading Strategy?
Iron Butterfly Option Strategy – An Example
Let’s assume that a certain company’s shares are trading at ₹100. So, the following are the four different trades that you can execute with an iron butterfly strategy.
- You can buy a put option with the strike price of ₹95 (at a value of ₹120)
- You can sell a put option with the strike price of ₹100 (at a value of ₹320)
- You can sell a call option with a strike price of ₹100 (at a value of ₹330)
- You can buy a call option with a strike price of ₹105 (at a value of ₹140)
Assume that all the above-listed options have a lot size of 100 stocks/shares.
Know More about F&O Stock List with Lot Size
So, here your overall gain would be ₹390, as you will receive ₹650 for selling the options and will pay ₹260 for buying the options. This means you will have a net credit overall.
Now, if the underlying stock value closes at the strike value of the short options at expiration, which is ₹100, here’s what you can expect:
- Option 1 will expire insignificant because it will give you the right to sell the options at ₹95 (instead of ₹100)
- Option 2 will expire insignificant because it will give the buyer the right to sell the options at ₹100 (which is the same as the market value)
- Option 3 will expire insignificant because it will give the buyer the right to buy the options at ₹100 (which is the same as the market value)
- Option 4 will expire insignificant because it will give you the right to buy the options at ₹105 (instead of ₹100)
Also Read: How To Buy & Sell Stocks?
Hence, after considering all aspects listed above, you will only experience the initial profits of ₹390 with the iron butterfly strategy. Whereas, if the stock closes in the market below the lower strike value or above, the higher strike value, you will have a greater risk of losing. Therefore, the iron butterfly option strategy is well-suited for investments when the market is less volatile.
The iron butterfly strategy is most suited for experienced traders. Here, the gains are on top when the stock price is at the centre strike value. So, it’s quite clear that the sweet spot lies in a narrow range. Hence, it takes a good deal of expertise to get this options trading strategy right. Again, it would be best not to try this strategy during volatile market conditions.
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Frequently Asked Questions
Only veteran and pro investors should make use of the iron butterfly strategy in options trading.
An iron condor strategy is a lower risk and lower reward position. On the other hand, an iron butterfly is a higher risk and higher reward position in the stock market. Since an iron butterfly's positions are kept close to or at the asset's/stock’s current value, it compiles higher premiums than that of an iron condor strategy.
An iron condor strategy includes buying and selling of calls and puts with different strike values when a trader expects low market volatility.
As a trader, you may incur a loss if the strike price closes above the price of the upper call or below the strike price of the lower put. Hence, you must know that profit will be higher when the middle strike price is nearer to the expiration.