Iron Butterfly Options Strategy – For High Reward per unit of Risk
For investors who want a high risk reward ratio in their investment; one strategy to apply is the Iron Butterfly Options Strategy aka Ironfly Strategy. This is a market-neutral strategy, used in a less volatile market; and pays the investor a net premium by combining a bull put spread with a bear call spread.
The strategy is named after the butterfly because the profit/loss graph of this strategy looks like the wings of a butterfly.
Let’s understand how to apply the strategy through an example of Stock X.
Current Market Price (CMP) = $99
$105 call: Premium for 1-month $105 call = $0.50
$100 call: Premium for 1-month $100 call = $3
$100 put: Premium for 1-month $100 put = $3
$95 put: Premium for 1-month $95 put = $0.70
To establish an Iron Butterfly spread:
Sell 10 units of 1-month $100 call and 10 units of 1-month $100 put options; so you’ll receive a premium of $60
Then, Buy 10 units of 1-month $105 call and 10 units of 1-month $95 put options; so you’ll pay a premium of $12
To calculate the Breakeven Points (BEPs), we will add/deduct the net premium received per unit ($4.80) from the exercise prices of the call and put options that we have sold ($100). So our BEPs would be:
Upper BEP: $100 + $4.20 = $104.20
Lower BEP: $100 – $4.20 = $95.80
In other words, as long as the stock price remains between $95.80 and $104.20, the investor will stay in profit. If the stock price goes above $104.20 or below $95.80; then the investor would start making a loss, with a limited maximum loss; as he/she has purchased $105 call options and $95 put options.
Profit and Loss Situation:
To understand the profit/loss situation and how this strategy has increased the risk reward ratio, let’s see the possible scenarios and how much profit or loss will be incurred in those scenarios:
Scenario 1: Stock price between $95.80 and $104.20 In this scenario, the investor will remain in a profit as the stock price is between his upper BEP and lower BEP. One of the options that he has sold will be in-the-money (ITM) and the other will be out-of-money; option-buyer will exercise the ITM option and the net premium received by the option-seller on the day of creation of the Iron Butterfly spread, will cover the loss incurred on it. When all the options expire out-of-money, then the maximum profit that can be realized in this scenario is $48 (net premium received on the day of creation of spread).
Scenario 2: Stock price below $95.80 In this scenario, $100 put option will be ITM and the investor will make a loss; limited maximum loss up to $0.80 per unit of stock; since he has purchased a $95 put which will be ITM when the stock goes below $95. In other words, the maximum possible loss in this scenario is $0.80 per unit i.e. $8.
Scenario 3: Stock price above $104.20 In this scenario, $100 call option will be ITM and the investor will make a loss, again with limited maximum loss up to $0.80 per unit of stock, since he has purchased $105 call option which will be ITM if the stock goes above $105. In other words, the maximum possible loss in this scenario is $0.80 per unit i.e. $8.
To wind-up the example, we can say that the investor has created a situation where he will be in a profit as long as the market remains within his expected range of $95.80 to $104.20 with a maximum possible profit of $48, and in case the market goes out of his expected range, then his maximum loss is limited to $8.
Conclusion
Iron Butterfly Options Strategy provides investors an opportunity to earn money in a non-volatile market situation while also providing a cushion in case the market goes against investor’s expectation and becomes volatile. Therefore, increasing the risk reward ratio of the investor.
There is limited profit potential in this strategy. Maximum profit that can be earned is capped at the net premium received on the day of establishing the spread for this strategy.
There is limited loss potential in this strategy. Maximum loss in any case is limited and is known to the investor at the time of entering into the strategy.
Do watch MKJ sir’s video on this topic at this link!