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Iron Butterfly

The document discusses an options trading strategy called an iron butterfly. It involves selling an at-the-money call and put option and simultaneously buying a further out-of-the-money call and put option to limit risk. This strategy profits when the underlying stock stays near the strike price by expiration. Exiting when the stock is closest to the strike price and near expiration allows traders to keep the profits from the initial credit received. The iron butterfly provides immediate income with limited downside risk compared to other options strategies.

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Patil Akash
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229 views3 pages

Iron Butterfly

The document discusses an options trading strategy called an iron butterfly. It involves selling an at-the-money call and put option and simultaneously buying a further out-of-the-money call and put option to limit risk. This strategy profits when the underlying stock stays near the strike price by expiration. Exiting when the stock is closest to the strike price and near expiration allows traders to keep the profits from the initial credit received. The iron butterfly provides immediate income with limited downside risk compared to other options strategies.

Uploaded by

Patil Akash
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Iron Butterfly

Probably my favorite thing about options is the ability to use them in developing strategies for
which profit when a stock trends sideways. When you know that a given stock will stay
sideways for quite a while, strategies such as the time spread can help you profit when stock
traders aren’t. In our course, we didn’t look at predicting sideways trends, but it’s actually quite
simple: We trade sideways strategies when the majority of our indicators are inconclusive.

Remember, this is a course focused on trading stock that has recently experienced a gap. This is
especially good for trading sideways strategies, as the gap has added to the implied volatility of
the stock. Trading sideways strategies on stock with high implied volatility tend to be more
profitable than doing the same on stock with low implied volatility.

If you read about the credit spreads under the “bullish” and “bearish” bonus sections, you’ll
find the iron butterfly easy to understand. When you run a debit spread and a credit spread at
the same time with the sold call and the sold put having the same strike prices, you have an
iron butterfly.

Here’s how it works: You sell an at-the-money (which means with a strike price as close to the
current stock price as possible) call and put contract – one each. At the same time, you buy a
call option with a higher strike price (say, $5 lower) and buy a put option at a lower strike price
(the distance should be the same - $5, for example).

You do this for an immediate profit, just as in a credit spread. Your goal is to close your position
(buy back all sold options and sell off all bought options) before the expiration date and when
the stock price is as close to the strike price of the sold options as possible.

Advantages of Playing an Iron Butterfly.

1. Immediate income.
2. Limited risk.
3. The largest amount of immediate income you can get from an options strategy that
allows you to set risk limits.

How to Open an Iron Butterfly

1. Sell a put/call option that’s as close to at-the-money as possible.


2. Sell a call/put option (the opposite of what you sold in step 1) at the same strike price.
3. Determine your maximum acceptable risk, in dollars, per iron butterfly strategy. Divide
that number by 100 and call it “x”. E.g., if our maximum risk is $500 per strategy, we’ll
get x = 5.
4. Buy a call option with a strike price x dollars higher than the sold call option. E.g., if our
sold call option has a strike price of $10, we will buy one with a strike price of $15.
5. Watch the stock as it approaches the expiration date of the sold option. Now you have
three choices:

Choice 1: Totally exit the position.


Buy back all sold options and sell all bought options. Do this when the stock looks stable.

Choice 2: Turn it into a call.


Buy back all sold options and sell the bought put. Now you’ve changed your strategy to a bullish
one. Do this when the stock looks extremely bullish and likely to pass the strike price of the
bought call.

Choice 3: Turn it into a put.


Buy back all sold options and sell the bought call. Now you’ve changed your strategy to a
bearish one. Do this when the stock looks extremely bearish and likely to pass the strike price of
the bought put.

Here is an example of what an iron butterfly should look like:


Exiting the Position

Though I’ve given you three options for exiting the iron butterfly, you generally want to go with
the first option. We only play iron butterflies when we are confident that the stock will remain
stable after a gap. The goal of the game is to get immediate income and “buy back” the iron
butterfly when it is cheapest, which is when the stock is at the strike price of the sold options and
when the options are close to the expiration date.

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