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Long Iron Butterfly Spreads: Understanding the Basics

Long Iron Butterfly Spreads: Understanding the Basics

Key Points
  • A long iron butterfly spread is a breakout strategy that may be appropriate to use when you expect the underlying security to experience a sharp move higher or lower, but you are uncertain which direction.

  • This four-legged options strategy, built with calls and puts, has three different strike prices and is established with the same contract quantity for each leg.

  • A long iron butterfly spread has a limited loss potential if the underlying security stays relatively stable rather than moving sharply.

  • We will look at how you might select strike prices for long iron butterfly spreads.

A long iron butterfly spread is a breakout strategy that may be appropriate to use when you expect the underlying security (stock or ETF) to experience a sharp move higher or lower, but you're uncertain which direction. This options breakout strategy has a limited loss potential if the underlying security stays relatively stable rather than moving sharply. 

Constructing a long iron butterfly spread

An iron butterfly is considered "long" when there is a net cash outlay required to initiate it. It is established with four legs, each with the same contract quantity and expiration date, and three different strike prices. Unlike traditional butterflies, which can be created using either calls or puts, long iron butterflies are created using both calls and puts at the same time.

To construct a long iron butterfly, you would:

  • Sell one put with the lowest strike price,
  • Buy one put with a higher strike price,
  • Buy one call with the same strike price as the previous put
  • Sell one call with the highest strike price.

Profit and loss profile for a long iron butterfly spread

Profit and loss profile for a long iron butterfly spread

Source: Schwab Center for Financial Research.

Typically, the strike prices are chosen such that the underlying instrument is trading very near the middle strike price. The strike price range between the first and second leg should be the same as the strike price range between the third and fourth leg.

How to calculate price levels

Your first step is to calculate the market price (net quote) of the long iron butterfly spread. To do so, find the sum of the individual leg prices using the bid prices on the legs you are selling and the ask price on the legs you are buying.

Calculating the net quote for a 10-point long iron butterfly spread

Legs Net quote (debit)

Sell 10 XYZ Dec 170 puts @ 4.05 bid

+4.05

= -8.10

Buy 10 XYZ Dec 180 puts @ 8.75 ask

-8.75

Buy 10 XYZ Dec 180 calls @ 5.45 ask

-5.45

Sell 10 XYZ Dec 190 calls @ 2.05 bid

+2.05

 

Like many option strategies, the maximum gain, maximum loss and breakeven points can all be calculated at the time of order entry.

Let's assume stock XYZ is trading at $177.98. The following formulas will allow you to calculate the maximum gain, maximum loss, and upper and lower breakeven prices on any long iron butterfly spread. (Note that commission charges are not included in the calculations below.)

Maximum loss
To calculate, multiply the debit paid by the number of spreads and by the standard options multiplier (typically 100).

8.10 (debit) x 10 (spreads) x 100 (options multiplier) = $8,100 (or 8.10)

Maximum gain
To calculate, subtract your first strike price from your second strike price and multiply the result by the number of spreads and by the standard options multiplier. Then, subtract the maximum loss.

180 (second strike) - 170 (first strike) x 10 (spreads) x 100 (options multiplier) = $10,000
$10,000 - $8,100 (maximum loss) = $1,900 (or 1.90)

Upper breakeven
Calculate the upper breakeven by adding the middle strike price and the maximum loss.

180 (middle strike) + 8.10 (maximum loss) = $188.10

Lower breakeven
Calculate the lower breakeven by subtracting the maximum loss from the middle strike price.

180 (middle strike) - 8.10 (maximum loss) = $171.90

Total cost of the trade
With long iron butterflies, the maximum loss and total debit are the same.

If you don't want to run these calculations yourself, StreetSmart Edge® can do it for you, as shown below.

Calculating maximum gain, maximum loss and breakeven price for a long iron butterfly spread

Calculating maximum gain, maximum loss and breakeven price for a long iron butterfly spread

Source: StreetSmart Edge.

Once you know these important values, consider drawing them on a price chart to help you visualize the trade. You'll probably want to include the outside strike prices of $170 and $190 (maximum gain levels) and the upper and lower breakeven levels of $188.10 and $171.90. A convenient way to do this is to use the support and resistance lines, which are typically used for technical analysis, to illustrate the breakeven and maximum loss levels. Use the resistance line tool (red line) for the inner breakeven lines, and the support line tool (green line) for the outer maximum gain levels, as illustrated below.

Breakeven price thresholds

Breakeven price thresholds

Source: StreetSmart Edge.

In the example above, the December long iron butterfly has about 45 days until expiration. If XYZ is between $171.90 and $188.10 at the December option expiration, this trade will be unprofitable. The maximum loss will be reached if XYZ is at exactly $180 at expiration.

This trade will be profitable if XYZ closes above $188.10 at expiration, with the maximum profit of $1,900 occurring at any price above $190. Likewise, the trade will also be profitable if XYZ closes below $171.90 at expiration, with the maximum profit of $1,900 also occurring at any price below $170.

As you can see, a long iron butterfly spread requires a fairly substantial move to be profitable, whereas the maximum loss can occur only at the middle strike price—$180 in this example. In addition, XYZ has to move up more than 10.12 points ($188.10 - $177.98), or down more than 6.08 points ($177.98 - $171.90) to end up profitable.

Keep in mind

A long iron butterfly is often used as a substitute for a short butterfly, except that a long iron butterfly is initially established for a net debit while the short butterfly is initially established for a net credit.

I hope this article enhanced your understanding of long iron butterflies. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call Schwab anytime at 800-435-9050.
-          Talk to a Schwab Financial Consultant at your local branch.

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(0315-1999)

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