Understanding Iron Butterfly

With this, we’ve finally reached the penultimate chapter of this module. Here, we’re going to take a look at the iron butterfly, which is an options strategy that you’ll soon find to be quite similar to the iron condor. So, let’s jump right in.

What is the iron butterfly?

Again, as with the iron condor, the iron butterfly is also a market-neutral options trading strategy. Designed to work in low-volatility environments, the iron butterfly strategy allows you to take advantage of range bound market situations. Although the strategy limits the maximum upside that you can enjoy, it helps you limit your downside risk as well.

How to set up an iron butterfly?

The iron butterfly is a four-legged strategy involving two call options and two put options, all with the same expiration date. Setting the options trading strategy up requires precise timing and therefore can be quite challenging at times. Let’s take a quick look at what you would have to do to set up an iron butterfly trading strategy.

• Buy 1 lot of put options at strike price A 
• Sell 1 lot of put options at strike price B
• Sell 1 lot of call options at strike price B
• Buy 1 lot of call options at strike price C

The strike prices A, B, and C should be equidistant and in an ascending order in terms of value. For instance, if the strike price A is 2,400, then the strike price B should be 2,500, and the strike price C should be 2,600. Confused? Don’t worry, the example that we’re going to take up in the next segment will help you understand it better.

How does the iron butterfly work?

Before we get to our example, let’s first take a look at a few of the assumptions that we’re going to make.

• You’re interested in purchasing the stock of Ashok Leyland Limited, which has been range bound for quite some time.
• The shares of the company are currently trading at Rs. 100.
• The lot size of the options contract of this stock is set at 9,000.
• The expiry date of all the options that we’re going to consider would be May, 2021.

Now that we’re done with the assumptions, here’s what you would have to do to construct an iron butterfly trading strategy.

• Purchase 1 lot of put options with a strike price of Rs. 95, which in this case would be ASHOKLEY MAY 95 PE. Let’s say that the premium for the put option is currently at Rs. 1.5 per share. So, to purchase 1 lot (which is 9,000 shares), you would have to pay Rs. 13,500 (Rs. 1.5 x 9,000).
• Sell 1 lot of put options with a strike price of Rs. 100, which in this case would be ASHOKLEY MAY 100 PE. Let’s say that the premium for the put option is currently at Rs. 2.5 per share. Therefore, by selling 1 lot (which is 9,000 shares), you would receive Rs. 22,500 (Rs. 2.5 x 9,000).
• Sell 1 lot of call options with a strike price of Rs. 100, which in this case would be ASHOKLEY MAY 100 CE. Assume that the premium for this call option is currently at Rs. 10 per share. So, by  selling 1 lot (which is 9,000 shares), you would receive Rs. 90,000 (Rs. 10 x 9,000).
• Purchase 1 lot of call options with a strike price of Rs. 105, which in this case would be ASHOKLEY MAY 105 CE. Let’s say that the premium for the put option is currently at Rs. 7 per share. So, to purchase 1 lot (which is 9,000 shares), you would have to pay Rs. 63,000 (Rs. 7 x 9,000).

As you can see from the above, all the three strike prices are equidistant (with a difference of Rs. 5) and in an ascending order. Now that you’re clear with the structure of the options strategy, let’s move onto the different scenarios and see how the iron butterfly trading strategy performs.

Scenario 1: The stock price stays at Rs. 100 on expiry 

According to the strategy, you’ve technically sold two lots of options and bought two lots of options. The net amount you receive from all of these trades combined would be Rs. 36,000 [(Rs. 90,000 + Rs. 22,500) - (Rs. 63,000 + Rs. 13,500)]. Keep this figure in mind.

Now, in the first scenario, if the stock of Ashok Leyland stays the same at Rs. 100 on expiry, here’s what would happen.

• The put options - ASHOKLEY MAY 95 PE that you purchased would expire worthless since the price increased.
• The put options - ASHOKLEY MAY 100 PE that you sold would also expire worthless since the strike price and the spot price are the same. 
• The call options - ASHOKLEY MAY 100 CE that you sold would expire worthless since the strike price and the spot price are the same. 
• The call options - ASHOKLEY MAY 105 CE that you bought would also expire worthless since the strike price is higher than the spot price.

Since all of the options have expired worthless, the net profit that you get to enjoy would be the amount that you were left with after executing the four-legged trade. In this case, the net profit would be Rs. 36,000. With the iron butterfly trading strategy, you get to enjoy maximum profit when all of the options expire worthless.

Scenario 2: The stock price falls below Rs. 95 on expiry

Now, let’s change the scenario a little bit. Assume that the stock price falls to Rs. 90 on expiry. What would happen? Here’s a quick look.

• The put options - ASHOKLEY MAY 95 PE that you purchased would make a profit of Rs. 5 per share, which comes up to Rs. 45,000 (Rs. 5 x 9,000).
• The put options - ASHOKLEY MAY 100 PE that you sold incur a loss of Rs. 10 per share, which would come up to Rs. 90,000 (Rs. 10 x 9,000).  
• The call options - ASHOKLEY MAY 100 CE that you sold would expire worthless since the strike price is higher than the spot price.  
• The call options - ASHOKLEY MAY 105 CE that you bought would also expire worthless since the strike price is higher than the spot price.

The total net loss that you would have to bear in this scenario would be Rs. 9,000 [(Rs. 90,000 - Rs. 45,000) - Rs. 36,000]. See how the downside was limited thanks to the options trading strategy?

Scenario 3: The stock price rises above Rs. 105 on expiry

Okay, so, let’s switch it up again. Let’s now assume that the stock price rises to Rs. 110 on expiry. Here’s what would happen then.

• The put options - ASHOKLEY MAY 95 PE that you purchased would expire worthless since the share price rose up. 
• The put options - ASHOKLEY MAY 100 PE that you sold would also expire worthless since the share price rose up. 
• The call options - ASHOKLEY MAY 100 CE that you sold would incur a loss of Rs. 10 per share, which would come up to Rs. 90,000 (Rs. 10 x 9,000). 
• The call options - ASHOKLEY MAY 105 CE that you bought would make a profit of Rs. 5 per share, which would come up to Rs. 45,000 (Rs. 5 x 9,000).

The total net loss that you would have to bear in this scenario would again come up to Rs. 9,000 [(Rs. 90,000 - Rs. 45,000) - Rs. 36,000].

Wrapping up

With the iron butterfly, irrespective of whether the price falls below the lowest strike price or rises above the highest strike price, you will always incur a loss. However, the loss will be limited. This is precisely why the iron butterfly strategy is used by traders in scenarios where the market is not highly volatile.

A quick recap

• As with the iron condor, the iron butterfly is also a market-neutral options trading strategy. 
• Designed to work in low-volatility environments, the iron butterfly strategy allows you to take advantage of range bound market situations. 
• Although the strategy limits the maximum upside that you can enjoy, it also helps you limit your downside risk as well. 
• The iron butterfly is a four-legged strategy involving two call options and two put options, all with the same expiration date. 
• To set up this strategy, you need to buy 1 lot of put options at strike price A.
• Then, you must sell 1 lot of put options at strike price B and sell 1 lot of call options at strike price B.
• Lastly, you need to buy 1 lot of call options at strike price C.
• The strike prices A, B, and C should be equidistant and in an ascending order in terms of value.