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The Iron Butterfly spread is created by entering into four contracts with three strike prices that get consecutively higher. Depending on whether buying or selling is going on, the two middle strike price options produce either a long or short “straddle”, where the investor has one put and one call which both have the same strike price and the same expiration date.
The “wings” of this iron butterfly are the options at the lower and the higher strike prices, and they are manifested by buying or selling into a “strangle”–that is, a call and a put at different strike prices but with both contracts having precisely the same expiration date.
A trader uses an Iron Butterfly to limit the amount of risk involved in the trading of options. Consequently, the potential reward is also relatively low due to the offsetting short and long positions.
So, if the underlying asset’s price falls sharply while you hold a short straddle at the middle strike price, your position is protected since you have that lower long put. On the flip side, if the price of the underlying asset rises you are protected by that higher long call.
An Iron Butterfly spread is used when you, the trader, are confident that the underlying asset or index that you’re trading has low volatility and is likely not to have its current trading price change, or change very much, before the expiration date of the contract. (There is also a strategy known as the Reverse Iron Butterfly spread, which traders use when they are confident that the price of the underlying asset or index is subject to high volatility and is likely to change dramatically.)
To enter into this strategy, you would buy: one out-of-the-money put and one out-of-the-money call; sell one at-the-money put; and, sell one at-the-money call. When you do this, you have a net credit put into your account.
What you are hoping for with your Iron Butterfly strategy is that the underlying asset’s price at expiration equals the strike price of the call and the put options when they are sold, letting every option contract you bought expire worthless to allow you to keep the whole net credit that you received. This is your highest possible profit.
The worst that can happen to you in the Iron Butterfly spread is that the stock price falls to or goes below the lower strike price of the put that you bought or rises to equal or exceed the higher strike price of the call that you bought. If one of these events happens, your loss equals the difference in strike price between the puts or calls less the net credit that your account received when you entered into the trade.
An Iron Butterfly spread also has two break-even points. These are figured as follows:
*The higher Break-even Point = The Short Call Strike Price + The Net Premium Received
*The lower Break-even Point = The Short Put Strike Price – The Net Premium Received
Remember that Iron Butterfly spreads can cost you a significant amount of money in commissions to your broker, as you must enter into four positions to enter into the trade.