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Options Strategy – Long Iron Butterfly


A Long Iron Butterfly is an options trading strategy that combines both a bull spread and a bear spread. It involves buying one lower strike call, selling two middle strike calls, and buying one higher strike call, all with the same expiration date. This strategy is used when a trader expects low volatility in the underlying asset’s price.

How It Works

  1. Buy a Lower Strike Call Option: The trader buys one call option with a lower strike price.
  2. Sell Two Middle Strike Call Options: The trader sells two call options with a middle strike price.
  3. Buy a Higher Strike Call Option: The trader buys one call option with a higher strike price.
  4. Profit and Loss: The maximum profit is achieved if the underlying asset’s price is at the middle strike price at expiration. The maximum loss occurs if the price is below the lower strike or above the higher strike.

Example of a Long Iron Butterfly Strategy

Let’s say you expect Company ABC, currently trading at $100, to remain around this price by the expiration date. You decide to implement a Long Iron Butterfly with the following specifics:

  • Buy Lower Strike Call: Strike Price $90, Premium Paid $2 per share
  • Sell Two Middle Strike Calls: Strike Price $100, Premium Received $5 per share
  • Buy Higher Strike Call: Strike Price $110, Premium Paid $1 per share
  • Expiration Date: 1 month from now

You trade one lower strike call, two middle strike calls, and one higher strike call option contract, each representing 100 shares. Your total net premium received (premium received from sold calls minus premium paid for bought calls) is:

(2×$5)−($2+$1)=$10−$3=$7 per share

Your total net premium received for 100 shares is:

100 shares×$7=$700  

Scenarios

  1. Stock Price at $100 (Middle Strike Price)
    If, at expiration, the stock price is at $100:
    • Lower Strike Call: Out of the money, expires worthless.
    • Middle Strike Calls: In the money, sold options are exercised, leading to a payout.
    • Higher Strike Call: Out of the money, expires worthless.
    • Net Profit: Total premium received ($700) minus any cost of exercise (if applicable).
  2. Stock Price Below $90 or Above $110
    If, at expiration, the stock price is below $90 or above $110:
    • Lower Strike Call: Below $90, out of the money, expires worthless.
    • Middle Strike Calls: Below $90, out of the money, expire worthless or above $110, leading to exercise.
    • Higher Strike Call: Below $90, out of the money, expires worthless or above $110, leading to a payout.
    • Net Loss: Maximum loss is the difference between the strike prices of the spreads minus the net premium received.
  3. Stock Price Between $90 and $110
    If, at expiration, the stock price is between $90 and $110:
    • Lower Strike Call: In the money, exercised, leading to a payout.
    • Middle Strike Calls: In the money, exercised, leading to a payout.
    • Higher Strike Call: Out of the money, expires worthless.
    • Net Profit: Depends on the exact stock price, with maximum profit achieved at $100.

Benefits of the Long Iron Butterfly Strategy

  • Limited Risk: The maximum loss is limited to the difference between the lower and middle strike prices minus the net premium received.
  • Defined Profit Range: The maximum profit is achieved if the stock price is at the middle strike price at expiration.

Risks of Long Iron Butterfly Strategy

  • Limited Profit Potential: The profit is limited to the net premium received.
  • Low Volatility Required: This strategy is effective only if the underlying asset’s price remains relatively stable.

The Long Iron Butterfly strategy is a conservative options trading approach that allows traders to capitalize on low volatility with limited risk.

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