Short Iron Butterfly Spreads: Understanding the Basics

A short iron butterfly spread is a neutral strategy you might want to consider when you expect a stock or ETF to remain in a narrow trading range.

A short iron butterfly involves four legs and three different strike prices established in a 1/1/1/1 ratio. Unlike traditional butterflies which can be created using calls or puts, iron butterflies are created using both calls and puts at the same time.

A short iron butterfly is a neutral strategy that has a limited loss potential if the underlying security moves sharply in either direction. An iron butterfly is considered "short" if a net credit is received when it is initiated:

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

Figure 1 – Basics of a short iron butterfly spread
Source: Schwab Center for Financial Research

The options should all have the same expiration date and the strike range between the first and second leg should be the same as the strike range between the third and fourth leg. Like many option strategies, the maximum gain, maximum loss, and breakeven points can all be calculated at the time of order entry.

How to calculate price levels for a Short Iron Butterfly

Assuming stock ZYX is trading at 167.01, the following formulas will allow you to calculate the maximum gain, maximum loss, and upper and lower breakeven prices on any short iron butterfly trade.

Example of a 10-point short iron butterfly spread:
Buy 5 ZYX Apr 155 puts @ 5.55
Sell 5 ZYX Apr 165 puts @ 9.05
Sell 5 ZYX Apr 165 calls @ 10.55
Buy 5 ZYX Apr 175 calls @ 6.35

CR (Credit) = 7.70 (-5.55 + 9.05 + 10.55 – 6.35)
MG (Maximum Gain) = 7.70 (Credit received x number of spreads) or \$3,850 (Occurs when the stock price is at the middle strike price)
ML (Maximum Loss) = 2.35 (first strike – second strike + credit x number of spreads) or \$1,150 (Occurs when the stock price is beyond the lowest and highest strike prices)
Upper BE (Breakeven) = 172.70 (Middle strike + MG)
Lower BE (Breakeven) = 157.30 (Middle strike – MG)

Or, you can simply allow StreetSmart Edge®

Figure 2 – Calculating maximum gain, maximum loss and breakeven for a short iron butterfly trade
Source: StreetSmart Edge®

The lines you'll want to show on the chart are the outside strike prices of 155 and 175 (represented by the red lines) and the upper and lower breakeven levels of 172.70 and 157.30 (represented by the green lines). Using the support and resistance line tool creates a chart as illustrated below:

Figure 3 – Breakeven thresholds
Source: StreetSmart Edge®

The snapshot of the chart above was taken on December 18, 2014 with the April short iron butterfly having about 121 days until expiration. If ZYX is between 157.30 and 172.70 at the April option expiration, this trade will be profitable. The maximum gain will be reached if ZYX is at exactly 165 at expiration. This trade will be unprofitable if ZYX closes above 172.70 or below 157.30, with the maximum loss of \$1,150 occurring at any price above 175 or below 155.

As you can see, short iron butterfly spreads require a fairly substantial move to be unprofitable, whereas the maximum gain can only occur at the middle strike price, 165 in this example. In this example the profit zone occurs over a range of 15.40 points (172.70 – 157.30). ZYX has to move up more than 5.69 points (172.70 – 167.01), or down more than 9.71 points (167.01 – 157.30) to end up unprofitable.

Keep in mind

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

The risk and reward profiles, and profit and loss zones of the two strategies are very similar, so the decision of which to use often comes down to which might have a very slight pricing advantage, or whether you prefer to pay a debit (with no margin requirement) or receive a net credit (with a margin requirement equal to the maximum loss).

Conclusion

A short iron butterfly is a neutral strategy—appropriate when you expect the underlying security to remain in a narrow trading range over the life of the options. This four-legged strategy, created using both calls and puts, has three different strike prices and is established with the same contract quantity for each leg. A short iron butterfly has a limited loss potential if the underlying security moves more than expected.

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