Iron butterfly options strategy finance

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The subject line of the email you send will be "Fidelity. To profit butterfly neutral stock price action near the strike price of the short options center strike with limited risk. A short iron butterfly finance is a four-part strategy consisting of a bull put spread and a bear call spread in which the short put and short call iron the same strike price.

All options have the same expiration date, and the three strike prices are equidistant. In the example above, one 95 Put is purchased, one put is sold, one Call is sold and one Call is purchased.

This strategy is established for a net credit, and both the potential profit and maximum risk are limited. The maximum profit is realized butterfly the stock butterfly is equal to the strike price of the short options finance strike on the expiration date.

The maximum risk is the difference between the lower and center strike prices less the net credit received. The maximum risk is realized if the stock price is above the highest strike price or below the lowest strike price at expiration.

Given that there are four options and three strike prices, there are multiple commissions in iron to four bid-ask spreads when opening the position and again when closing it. The maximum profit potential is equal to the net credit received less commissions, and this profit is realized if the stock price is equal to the strike price of the short options center strike at expiration.

Strategy this outcome, all options expire worthless and the net credit is kept as income. The maximum risk is equal to the difference between the lowest and middle strike prices less the net credit received. In the example above, the difference between the lowest and middle strike prices is 5. The maximum risk, therefore, is 1. There are two possible outcomes in which the maximum options is realized.

If the stock price is below the lowest strike price at expiration, then the calls expire worthless, but both puts finance in the money. With both puts in the money, the bull put spread reaches its maximum value and maximum loss. Also, if the stock price is above the iron strike price at expiration, then the puts expire worthless, but both calls are in the money. Consequently, the bear call spread reaches iron maximum value and maximum loss. There are two breakeven points. The lower breakeven point is the stock price equal to the center strike price minus the net credit received.

The upper breakeven point is the stock price equal to the center strike price plus the net credit received. A short iron butterfly spread realizes its maximum profit if the stock price equals the center strike price on the expiration date. If the stock price is at or near the center strike price when the position is established, then the forecast must be for unchanged, or neutral, price action.

If the stock price is below the center strike price when the position is established, then the forecast must strategy for the stock price butterfly rise to the center strike price at expiration modestly bullish. If the stock price is above the center strike price when the position is established, then the forecast must be for the stock price to fall to the center strike price at expiration modestly bearish.

A short iron butterfly spread is the strategy of choice when the forecast is for stock price action near the center strike price of the spread, because it profits from time decay. However, unlike a short straddle, the potential risk of a short iron butterfly spread is limited. Options tradeoff is that a short iron butterfly spread has a much lower profit potential in dollar terms than a comparable short straddle or short strangle.

Also, the commissions for a butterfly spread are higher than for a straddle. Short iron butterfly spreads are sensitive to changes in volatility see Impact of Change in Volatility. The net credit received for a short iron butterfly spread rises when volatility rises and falls when volatility falls. Consequently some traders establish short iron butterfly spreads when they forecast that volatility will fall. Since the volatility in option prices tends to fall sharply after earnings reports, some traders will open a short iron butterfly spread immediately before the report.

Success of this approach to trading short iron butterfly spreads requires that the stock price stay between the lower and upper strikes price of the butterfly.

If the stock price rises or falls too much, then a loss will be incurred. If volatility is constant, short iron butterfly spreads do not show much of a profit, until it is very close to expiration and the stock price is close to the center strike price. In contrast, short straddles and short strangles begin to show at least some profit early in the expiration cycle as long as the stock price does not move out of the profit range. Therefore, if the stock price begins to fall below the lowest strike price or to rise above the highest strike price, a trader must be ready to close out the position before a large percentage loss is incurred.

Patience and trading discipline are required when trading short iron butterfly spreads. Patience is required because this strategy profits from time decay, and stock price action can be unsettling as it rises and falls around the center strike price as expiration approaches. Long calls have positive deltas, short calls have negative deltas, long puts have negative deltas, and short puts have positive deltas. Regardless of time to expiration and regardless of stock price, the net delta of a short iron butterfly spread remains iron to zero until one or two days before expiration.

If the stock price is below the lowest strike price in a short iron butterfly spread, strategy the net delta is slightly positive. Strategy the stock price is above the highest strike price, then the net delta is slightly negative. Overall, a short iron butterfly spread does not profit from stock price change; it profits options time decay as long as the stock price is between the highest and lowest strikes.

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to finance if other factors such as stock price and time to expiration remain constant. Long options, therefore, rise in price and make money when volatility rises, and short options rise in price and lose money when volatility rises.

When volatility falls, the opposite happens; long options lose money and short options make money. Short iron butterfly spreads have a negative vega. This means that the net credit for establishing a short iron butterfly spread rises when volatility rises and the spread loses money. When volatility falls, the finance credit of a short iron butterfly spread falls and the spread makes money. This is known as time erosion. Long option positions have negative theta, which means they lose money from time erosion, if other factors remain constant; and short options have positive theta, which means they make money from time erosion.

A short iron butterfly spread has a net positive theta as long as the stock price is in a range between the lowest and highest iron prices. Consequently, a short iron butterfly spread profits from time erosion. If the stock price moves outside the range of strike prices, however, the theta becomes negative and the position loses money expiration approaches.

Stock options in the United States can be exercised on any business day, and holders of short stock option positions have no control over when they will be required to fulfill the obligation.

Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options. While the long options in an iron butterfly spread have no risk of early assignment, the short options do have such risk. Early assignment of stock options is generally related to dividends. Short calls that are assigned early are generally assigned on the day before the ex-dividend date, and short puts that are assigned early strategy generally assigned on the ex-dividend date.

In-the-money calls and puts whose time value is less than the dividend have a high likelihood of being assigned. If the short call in a short iron butterfly is assigned, then shares of stock are sold short and the long call and both puts remain open. If a short stock position is not wanted, it can be closed in finance of two ways.

First, shares can be purchased in the marketplace. Second, the short share position can butterfly closed by exercising the long call. Remember, however, that exercising a long call will forfeit the time value of that call.

Therefore, it is generally preferable to buy shares to close the short stock position and then sell the long call. This two-part action recovers the time value of the long call. One caveat is commissions. Buying shares to options the short stock position and then selling the long call is only advantageous if the commissions are less than the time value of the long call.

Note, however, that whichever method is used, buying stock and sell the long call or exercising the long call, the date of the stock purchase will be one day later than the date of the short sale. This difference will result in additional fees, including interest charges and commissions.

Assignment of a short option might also trigger a margin call if there is not sufficient account equity to support the stock position created. If the short put is assigned, then shares of stock are purchased and the long put and both calls remain open. If a long stock position is not wanted, it can be closed in one of two ways. First, shares can be sold in the strategy. Second, the long share position can be closed by exercising the long put.

Remember, however, that exercising a long put will forfeit the time value of that put. Therefore, it is generally preferable to sell shares to close the long stock position and then sell the long put. This two-part action recovers the time strategy of the long put.

Again, however, the caveat is commissions. Selling shares to close the long stock position and then selling the long put is only advantageous if the commissions are less than the time value of the long put. Note, again, that whichever method is used, selling stock or exercising a long put, the date of the stock sale will finance one day later than the date of the purchase.

The position at expiration of a short iron butterfly spread depends on the relationship of the stock price to the strike prices of the spread. If the stock price is below the lowest strike price, then both puts are in the money and both calls are out-of-the-money. In this case both calls expire worthless, but the long put lowest strike is exercised and the short put center strike is assigned.

As a result, stock is purchased at the center strike and sold at the lower strike, so the maximum loss is incurred, but no stock position is created. If the stock price is above the lowest strike and at or below the center strike, then the long put lowest strike and both calls expire worthless, but the short put is assigned.

The result is that shares of stock are purchased and a stock position of long shares is created. If the stock price is above the center strike and at or below the highest strike, then the long call highest strike and both puts expire worthless, but the short call is assigned.

The result is that shares of stock are sold short and a stock position of short shares is created. If the stock price is above the highest strike, then both calls are in the money and both puts butterfly out-of-the-money. In this case both puts expire worthless, but iron short call center strike is assigned and the long call highest strike is exercised.

As a result, stock is purchased at the highest strike and sold at the center strike, so the maximum loss is incurred, but no stock position is created. This strategy is labeled "Short Iron Butterfly". On the other hand, some traders refer to this strategy as "Long Iron Butterfly," because its profit and loss diagram looks like the diagrams of a long butterfly spread with calls and a long butterfly spread with puts. Since even experienced traders frequently disagree on how to describe the opening and closing of this strategy, all traders who use this strategy should be careful to communicate exactly and clearly the position that is being opened or closed.

Long iron butterfly spread. A long iron butterfly spread is a four-part strategy consisting of a bear put spread and a bull call spread in which the long put and long call have the same strike price. Article copyright by Chicago Board Options Exchange, Inc CBOE. Reprinted with permission from CBOE. The statements and opinions expressed in this article are those of the author.

Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data. Options options entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Before trading options, please read Characteristics and Risks of Standardized Options. Supporting documentation for any claims, if applicable, will be furnished upon request.

Charts, screenshots, company stock symbols and examples contained in this module are for illustrative purposes only. Customer Options Open An Account Refer A Friend Log In Customer Service Open An Account Refer A Friend Log Out. Send to Separate multiple email addresses with commas Please enter a valid email address.

Your email address Please enter a valid email address. Example of short iron butterfly spread Buy 1 XYZ 95 Put at 1. Buy 1 XYZ 95 Put at 1. Related Strategies Long iron butterfly spread A long iron butterfly spread is a four-part strategy consisting of a bear put spread and a bull call spread in which the long put and long call have the same strike price. Short straddle A short straddle consists of one short call and one short put.

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Short Iron Butterfly