There are plenty of ways to profit on a stock's movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.
A call is an options contract that gives the owner the right to purchase the underlying security at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.
An iron butterfly is a relatively advanced strategy that seeks to profit if a stock closes at a very specific price. This strategy is ideal for a stock with low volatility, and it is overall a low-risk and low-reward trade.
The basic setup
An iron butterfly consists of selling one call spread and one put spread: a bullish put spread combined with a bearish call spread. You would sell an at-the-money put, then purchase another put with a lower strike price to create a vertical spread. Then, you would sell an at-the-money call, then purchase another call with a higher strike price to create a second vertical spread. Typically, the spread widths will be equal, but you could customize your position depending on your outlook on the stock. In an iron butterfly, the short call and short put have identical strike prices.
An iron butterfly is very similar to an iron condor, except an iron condor has distance between the middle strike prices.
For example, let's say a stock is trading at $50 and you expect it to close at $50 upon expiration. To initiate an iron butterfly, you could sell a $50 put, purchase a $45 put, sell a $50 call, and purchase a $55 call. Let's say that the $50 put and $50 call are trading at $2 (they should have comparable prices due to put/call parity), while the $45 put and $55 call are trading at $1. That would result in a net credit of $1 per spread, or a $2 net credit for all four legs.
Maximum gain: net credit
The most that you can make on an iron butterfly is simply the net credit received. This occurs if the stock price closes upon expiration at exactly the middle strike price. In this scenario, all options expire worthless and you keep all premiums received. There is limited profit potential for an iron butterfly.
In this example, if the stock closed upon expiration at exactly $50, you would keep the $2 net credit.
Maximum loss: difference in strike prices minus net credit
One appeal of iron butterflies is that they have very limited risk. The most that you can lose is the difference in strike prices of one of the spreads, minus the net credit received. As mentioned above, the spread widths will typically be equal, but choosing different spread widths can potentially affect your maximum loss point. The wider spread would determine your maximum potential loss.
This max loss occurs if the stock price closes upon expiration either beneath the lower put strike, or above the higher call strike. In other words, if the stock price passes completely through one of the spreads, then the maximum loss will occur but is partially offset by the net credit received. It goes without saying that the stock price cannot close in two places at once, so only one spread can potentially generate its max loss.
In this example, if the stock closed below $45, you would have to purchase the stock at $50 due to the short $50 put, then sell it at $45 by exercising the long $45 put, resulting in a $5 loss. The $2 net credit would offset some of this loss for a total max loss of $3. Alternatively, if the stock closed above $55, you would be selling the stock at $50 due to the short $50 call, while buying the stock at $55 due to the long $55 call, similarly resulting in a $5 loss that would also be offset by the $2 premium for a total max loss of $3.
Breakeven: middle strike plus or minus net credit
Since an iron butterfly consists of two vertical spreads with an overlapping middle strike price, there are two breakeven points. If the stock price increases above the middle strike, then the call spread begins to lose value. If the stock price decreases below the middle strike, then the put spread begins to lose value.
In this example, if the stock closed at $52, the $2 in losses associated with the call spread would be offset by the $2 in net credit received. If the stock closed at $48, the $2 in losses associated with the put spread would be offset by the $2 in net credit received.
The article What Is an Iron Butterfly? originally appeared on Fool.com.
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