What is an iron butterfly?
An iron butterfly is a type of trading strategy consisting of multiple legs. A trader who establishes an iron butterfly position will sell-to-open a short straddle, buy-to-open a call option above the straddle's strike price, and also buy-to-open a put option below the straddle's strike price. All the option contracts in this position share the same expiration date.
The iron butterfly strategy is like a short straddle with long option protection. This setup results in two credit spreads: one is a bear call spread and the other is a bull put spread. They both have the same expiration date and are centered around the same short strike price.
Iron butterflies are typically sold when the options prices trade at the same as the underlying asset. However, they can be entered above or below the stock price to express a bias that is bullish or bearish.
When to use an iron butterfly strategy
Iron butterflies are a market-neutral strategy, meaning they are a fit for traders who do not have a strong opinion about the direction of the underlying stock. In fact, they generate profit when the stock does not move much at all.
Therefore, iron butterflies are most commonly used when a trader expects a stock to stay within a certain range before the associated options expire, and when he or she also believes that implied volatility will go down.
How to manage an iron butterfly position
Iron butterflies are a trading strategy that profits from time decay. What a trader with this position is hoping for is that all the options in the iron butterfly spread expire worthless, with the underlying stock settling at the middle strike price.
The effect of implied volatility on an iron butterfly trade depends on where the underlying stock is trading relative to the strike prices of the position. If the stock price stays around the middle strike, a trader will want the implied volatility to go down. This is because the trader sold two options at that strike. So if implied volatility goes down, those options will be worth less.
Iron butterfly maximum profit potential
The most money you can make with an iron butterfly is the credit you receive when you put the trade on.
Iron butterfly maximum loss potential
Iron butterflies have a set amount of risk. The risk is limited to the value of the middle strike minus the lower strike, minus the net credit you earned when you created the position.