Short Iron Butterfly spread

Short Iron Butterfly spread

Short Iron Butterfly spread

The Short Iron Butterfly spread is a way to profit from neutral stock price action near the strike price of the short options (center strike) with limited risk.

It is is a four-part strategy consisting of

  • a bull put spread, and
  • a bear call spread

in which the short put and short call have 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 100 put is sold,
  • one 100 Call is sold
  • one 105 Call is purchased.

This strategy is established for a net credit, and both the potential profit and maximum risk are limited.

This is an advanced strategy because the profit potential is small in dollar terms and because “costs” are high.

Given that there are four options and three strike prices, there are multiple commissions in addition to four bid-ask spreads when opening the position and again when closing it. As a result, it is essential to open and close the position at “good prices.” 

The maximum profit is realized if the stock price is equal to the strike price of the short options (center strike) on the expiration date.

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

If the stock price is below the lowest strike price at expiration, then the calls expire worthless, but both puts are in the money. With both puts in the money, the bull put spread reaches its maximum value and maximum loss.

If the stock price is above the highest strike price at expiration, then the puts expire worthless, but both calls are in the money. Consequently, the bear call spread reaches it 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.

Appropriate market forecast

A short iron butterfly spread realizes its maximum profit if the stock price equals the center strike price on the expiration date.

The forecast, therefore, can either be “neutral,” “modestly bullish” or “modestly bearish,” depending on the relationship of the stock price to the center strike price when the position is established.

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 be for the stock price to 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).

Strategy discussion

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.

The 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.

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.

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.

Furthermore, while the potential profit of a short iron butterfly spread is a “high percentage profit on the capital at risk,” the typical potential dollar profit of one iron butterfly spread is “low.”

As a result, it is often necessary to trade a large number of iron butterfly spreads if the goal is to earn a profit in dollars equal to the hoped-for dollar profit from a short straddle or strangle.

Also, one should not forget that the risk of a short iron butterfly spread is still 100% of the margin requirement, which equals the maximum risk. 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.

Trading discipline is required, because, as expiration approaches, “small” changes in stock price can have a high percentage impact on the price of a butterfly spread. Traders must, therefore, be disciplined in taking partial profits if possible and also in taking “small” losses before the losses become “big.”

Impact of stock price change

“Delta” estimates how much a position will change in price as the stock price changes. 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 close 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, then the net delta is slightly positive.

If 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 from time decay as long as the stock price is between the highest and lowest strikes.

Impact of change in volatility

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 rise 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. “Vega” is a measure of how much changing volatility affects the net price of a position.

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 net credit of a short iron butterfly spread falls (and the spread makes money).

Short iron butterfly spreads, therefore, should be established when volatility is “high” and forecast to decline.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion.

“Theta” is a measure of how much time erosion affects the net price of a position.

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 strike 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.