Iron Butterfly Options Strategy | What are Iron Butterflies?
The iron butterfly options strategy is an excellent way to short volatility and take advantage of theta decay as an options trader.
Key Takeaways
The iron butterfly is an options trading strategy where an investor sells both a call option and a put option with the same strike price, and buys a call option and a put option at different strike prices, all with the same expiration date.
The strategy is typically used when an investor believes that the underlying asset will remain within a certain price range and there will be low volatility.
The potential profit for an iron butterfly is limited to the premiums received from selling the call and put options, while the potential loss is limited to the difference between the strike prices of the options purchased and sold.
What is an Iron Butterfly?
An iron butterfly (iron fly) is a neutral options strategy where you are shorting volatility with the ATM call and put options. When you trade the iron butterfly, you want the underlying to stay in a tight range while implied volatility decreases to make a profit.
The iron butterfly consists of an ATM short straddle where you also buy further OTM wings within the same expiration, making it a defined risk play.
How to Set Up an Iron Butterfly?
To set up an iron butterfly, you start by selling the ATM straddle, which is when you sell an ATM call and put.
Next, you buy a lower strike put and a higher strike call to make the wings. Generally, you want the distance between the short and long options to be equal.
For example, if you sell a $100 strike call and put, you could buy the $90 strike put and the $110 strike call. Essentially, you are selling a put credit spread and a call credit spread with the same short strike price.
Iron Butterfly Payoff Diagram
The payoff diagram of an iron butterfly portrays a small profit tent in which the stock must be for you to generate a profit at expiration.
Since iron butterflies are a defined risk trade, there is a maximum loss shown by the red areas outside the profit tent.
As time goes on, the profit within the tent will increase thanks to theta decay. However, you can lose money if the stock goes outside the profit tent.
Implied Volatility Impact on Iron Butterflies
The iron butterfly is a short premium trade, meaning it benefits from a decline in implied volatility. After opening an iron butterfly, the best-case scenario is that the stock doesn’t move and implied volatility drops.
If implied volatility increases after you open an iron butterfly, your trade will likely show a loss. However, the benefit of iron butterflies is you collect a lot of premium upfront, meaning your max loss is generally much lower than an iron condor.
Theta Decay and Iron Butterflies
Theta decay is a crucial component when trading the iron butterfly options strategy. Other than a decrease in implied volatility, time decay is the other driver to generating a profit trading the iron butterfly.
Since you are short premium when trading iron butterflies, you want options prices to decrease. Theta decay benefits option sellers while it hurts option buyers. However, if the stock moves too quickly in either direction, gamma can negate all the theta decay, and you can lose money.
When to Trade an Iron Butterfly?
The ATM strikes have the most extrinsic value. Therefore, it is best to trade iron butterflies when implied volatility is high.
Additionally, you should trade iron butterflies when you believe the stock will be rangebound and not move much. If the stock moves too far away from the short strikes, the iron butterfly will likely lose money unless the volatility drops hard enough to counter the stock move.
When to Exit an Iron Butterfly?
When trading iron butterflies, you should have an exit strategy planned out before getting into the trade. Many options traders seek to collect about 25% of the premium as a profit-taking level.
Therefore, if you collect $2.50, you can buy the iron butterfly back at $1.87 to collect 25% of the premium. Iron butterflies are a defined risk trade, so many options traders do not use a stop loss.
Iron Butterfly Options Strategy | Bottom Line
The Iron Butterfly options strategy is a neutral trade that seeks to profit from a decrease in implied volatility and benefits from time decay. The strategy consists of selling an ATM straddle and buying further OTM wings within the same expiration.
It is a defined risk trade, with a maximum loss shown by the red areas outside the profit tent. When trading an iron butterfly, it is important to understand the impact of implied volatility and theta decay and to have an exit strategy in place.
The best time to trade an iron butterfly is when implied volatility is high, and the stock is expected to be rangebound. With a proper understanding of the Iron Butterfly options strategy, traders can effectively utilize this strategy to generate profits in the options market.
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