This option trading strategy is pretty much the exact reverse of the Long Iron Butterfly. In contrast to the latter, where you are anticipating the underlying stock to remain within a trading range as a prerequisite to implementing the strategy, a Short Iron Butterfly can be considered when you believe a price breakout is imminent.
Do NOT use Short Iron Butterflies for range-trading stocks!
Another important consideration is, that this approach is an alternative to a Straddle trade – the only difference being that theoretically a Straddle has unlimited profit potential whereas the Short Iron Butterfly’s profit is limited. However, the Short Iron Butterfly is usually cheaper to purchase, due to the ’sold’ out-of-the-money positions offsetting the cost.
How to Set Up the Position
The basic idea is that you are combining two debit spreads – one with an upward aspect and comprising call options, the other facing downwards and using put options.
You BUY the same number of ‘at the money’ (ATM) call and put options – in the same way you would for a Straddle.
You also SELL the same amount of call and put options, only further ‘out of the money’ (OTM) on either side of the current market price of the underlying stock – calls above, puts below.
As a result of the above, you will incur a net debit to your account, since ATM options are more expensive than OTM options.
Risk and Reward Profile
As with most options positions, the Short Iron Butterfly has limited risk. In this case, your maximum risk is limited to the net debit, ie. the cost of the position.
The potential profit is also limited to the difference between the strike prices on one side of the trade at expiry date, less the net debit incurred on entering the position.
You should always construct a risk-to-reward table before entering the trade. If the potential maximum profit at expiry date is at least 200 percent and you feel confident the stock is about to make a sharp move in either direction sometime soon, then the Short Iron Butterfly may be an attractive alternative to the Straddle.
Exit Strategies
If the underlying stock falls below the lowest strike price (puts) or rises above the highest strike price (calls) you will be in the profit zone. If you are confident the stock will not rebound before expiry date, you can consider closing out one side of the trade and letting the other side expire worthless. This will minimize your brokerage costs on exit.
If the stock remains within the upper and lower breakeven points, you are facing a potential loss. The breakeven points at expiry will be the highest strike price minus the net debit or lowest strike price plus the net debit on entry. Because this is a strategy where you are relying on one of the ATM options to make sufficient profit to cover your net initial debit, plus some – and this looks unlikely – you should close out your positions and realize the maximum loss previously mentioned.
Conclusion
In order to make a profit from this strategy, the underlying stock needs to make a significant move, preferably earlier than later. The upside of the deal is that will be cheaper to enter than the straddle, but you need to take extra brokerage costs into account and decide whether there is an economy of scale here. The further away you set your outer strike prices, the more likely you are to realize a profit in the event of an early move. But if the premium you receive from your OTM sold options hardly covers the extra brokerage fees, you’re better off sticking with a Straddle or Strangle.
Owen has traded options for many years. Visit his popular blog to discover powerful Option Trading Strategies including when to use the Short Iron Butterfly.
