Among the more creative names for option strategies is the iron butterfly. In a basic butterfly, you combine two spreads, creating a position with limited risk and limited profit potential. The iron butterfly, in comparison, is a straddle plus a combination and involves four options instead of the three found in the straight butterfly.
The iron butterfly may be either long or short, depending on the net effect of the four options. In a long butterfly, you open a long call and a long put with the same strike; and then add a lower short put and a higher short call. For example, an iron butterfly may include:
long 80 put
long 80 call
short 75 put
short 85 call
Because this includes long and short positions, the net cost is going to be quite small and could even involve a small net credit. The long butterfly creates an extremely small “loss zone” within a few points of the middle strike; and a fixed profit zone both above and below. Once price begins moving substantially in either direction, that profit remains fixed because the long and short options offset one another (above the high call strike or below the low put strike).
In a short iron butterfly, the same idea applies – a combination of four options and three strikes – but the outcome involves a limited profit zone in the middle range, and a fixed loss zone above and below. A short iron butterfly includes short call and put in the middle and long positions both above and below:
Like the long iron butterfly, in the short version, the net cost/credit of this position is going to be quite small. This sets up the small profit zone and a fixed loss zone above or below, which raises a question about the iron butterfly: When it is advantageous?
For many traders, the limitations on either long or short iron butterflies make the strategy limited in value. Considering the margin requirements, setting up a complex pattern of offsetting options ties up capital while limiting opportunity. However, there are instances when the iron butterfly is attractive. These include limitation of risk in an uncertain environment. For example, you might expect a stock to move significantly, but you do not know in which direction. For example, takeover rumors create a lot of interest. If the takeover goes through, you expect the price to jump; if it fails, you expect the price to tumble. In this case, a long iron butterfly suits your needs well.
It can also be a suitable strategy in a swing trading approach when you expect volatility and price movement in one direction or the other. As part of an options-based swing trade or as an offset to long stock positions, the iron butterfly can reduce your risk while allowing you to reap modest profits.
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