What it means
An option is a contract giving the right, but not the obligation, to buy (a call) or sell (a put) an asset at a set price, called the strike price, before a certain date. In an iron butterfly the trader sells a call and a put at the same middle strike, usually close to the current price.
This short straddle collects a large premium, but on its own it carries unlimited risk if the price moves sharply. To cap that risk, the trader buys a call at a higher strike and a put at a lower strike, called the wings.
These cost money but protect against large moves in either direction. The result is a position with four legs: a long put, a short put, a short call and a long call.
The trade earns its maximum profit if the asset finishes exactly at the middle strike on the expiry date, because then all the options sold expire worthless. The profit falls as the price moves away in either direction, and it turns into a loss beyond the break-even points.
The greatest possible loss is the distance between the middle and wing strikes, less the premium received. Traders use the strategy when they expect low volatility, meaning small price movements, for example after an earnings announcement or during a quiet holiday period.
Time works in the trader's favour, because the options sold lose value as the expiry nears. The strategy also tends to benefit from falling implied volatility, which is the market's expectation of future price swings.
There are costs and risks. Four legs mean four sets of commissions and bid-ask spreads, which reduce the small profit, and the position can be assigned early on a short option.
The trader also needs enough margin to cover the maximum loss, and businesses rarely use the strategy for hedging.
In practice
Real-world examples.
Example
A trader expects a stable share price in the weeks after quarterly results are released. He builds an iron butterfly centred on the current price and collects a net credit that he keeps if the share stays within a narrow range.
Example
A portfolio manager who already owns shares uses the strategy on an index for a quiet month. She accepts that the profit is small, but the capped loss means a sudden market move will not cause a large damage to her account.
Example
A student in a finance course models the strategy in a spreadsheet. She plots profit against the final share price and sees the tent-shaped payoff, with the peak at the middle strike and flat losses beyond the wings.
Formula
Calculation
Net credit = premiums received on short options - premiums paid on long options
Maximum profit = net credit
Maximum loss = width of wing - net credit
Break-even points = middle strike plus or minus net credit
A share trades at $100. A trader sells a $100 call for $3.00 and a $100 put for $3.00, receiving $6.00. She buys a $105 call for $1.00 and a $95 put for $1.00, paying $2.00. The net credit is 6.00 - 2.00 = $4.00 per share, or $400 for one contract of 100 shares. The maximum profit is $400 if the share finishes at $100. The wing width is 105 - 100 = $5, so the maximum loss is 5 - 4 = $1 per share, or $100. The break-even prices are 100 - 4 = $96 and 100 + 4 = $104.Case study
Seen in the real world.
Pemberton Capital is an illustrative, fictional trading firm whose analyst expected a utility share, currently at $50, to stay calm until the end of the month. He sold the $50 call and put for a total of $3.20 and bought the $55 call and $45 put for a total of $1.20.
The net credit was 3.20 - 1.20 = $2.00 per share, and the maximum loss was 5 - 2 = $3.00 per share. On the expiry date the share closed at $51, so the call he sold was $1 in the money. His loss on that leg was $1.00 and the other options expired worthless, leaving a profit of 2.00 - 1.00 = $1.00 per share, or $100 per contract before commissions.
The illustrative lesson is that the strategy paid because the price stayed near the middle strike, and that the capped risk gave the firm certainty about the worst case.
Watch out
Common mistakes.
- Believing the maximum profit is easy to achieve, when it requires the price to finish exactly at the middle strike.
- Ignoring commissions and bid-ask spreads, when four legs can eat much of a small premium.
- Confusing it with a regular butterfly spread, when the iron version uses both calls and puts and is built for a net credit.
Questions
People also ask.
What is the difference between an iron butterfly and an iron condor?
An iron butterfly sells both options at the same middle strike, while an iron condor sells options at two different strikes, giving a wider profit zone but a smaller maximum profit.
When does the strategy lose money?
It loses if the price finishes beyond the break-even points, and the loss is largest at or beyond the wing strikes.
Why do traders like it?
The risk is defined in advance and time decay works in the trader's favour if the price stays put.
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