What is the Iron Butterfly Strategy and How to Build This Strategy?

You may be familiar with bullish and bearish options trading strategies. These trades are designed to be profitable in either upward or downward price movement scenarios. However, asset prices may not always react so strongly by expiry. Sometimes, the price of the underlying asset may be less volatile and trade within a defined range. 

If you expect this kind of price stability, you need profitable options trading strategies that can leverage the low volatility in the underlying asset. The iron butterfly is one of the most popular strategies in this category. 

In this article, we take a deep dive into the iron butterfly strategy and decode its setup and outcomes. 

What is the Iron Butterfly Strategy?

The iron butterfly is a strategy that uses both call and put options to capitalise on limited price movement in an asset. More specifically, this strategy uses two calls and two puts and involves three different strike prices. The middle strike price must be equidistant from the lower and upper strike prices. This is crucial to make the iron butterfly options trading strategy profitable. 

The setup is designed to limit the risk for the trader in a neutral market with high implied volatility in the asset. However, it also simultaneously limits the profit possible from the trade. So, if you are a conservative or moderate risk-taker with a limited risk tolerance, this potentially profitable options trading strategy may be ideal for you. 

How to Build the Iron Butterfly Strategy?

The four-legged iron butterfly strategy is set up using the following four trades involving call and put options — all with the same underlying asset and date of expiry. 

• Trade 1: Purchase an out-of-the-money (OTM) put option with a strike price A
• Trade 2: Write an at-the-money (ATM) put option with a strike price B
• Trade 3: Write an at-the-money (ATM) call option with a strike price B
• Trade 4: Purchase an out-of-the-money (OTM) call option with a strike price C

Here, strike price B is generally the current market price of the underlying asset. Strike price A is lower than strike price B, while strike price C is higher. Both A and C are equidistant from B. 

Setting up the Iron Butterfly: An Example for Beginners

If you are a beginner to complex profitable options trading strategies, the iron butterfly’s setup may be a bit difficult to comprehend. Let us make this easier for you with a hypothetical example. 

Say a company’s shares are trading in the spot market at Rs. 200. You expect that its price will not swing significantly within the next few days or weeks. So, you believe that the iron butterfly could be a profitable options trading strategy in this market scenario and execute the following four trades using call and put options with a lot size of 100 shares each. 

• Trade 1: Purchase one lot of an OTM put option with a strike price of Rs. 190 for a total premium of Rs. 4.80 per share (total premium of Rs. 480)
• Trade 2: Sell one lot of an ATM put option with a strike price of Rs. 200 for a premium of Rs. 7.00 per share (total premium of Rs. 700)
• Trade 3: Sell one lot of an ATM call option with a strike price of Rs. 200 for a premium of Rs. 5.50 per share (total premium of Rs. 550)
• Trade 4: Purchase one lot of an OTM call option with a strike price of Rs. 210 for a premium of Rs. 2.50 per share (total premium of Rs. 250)

For this setup, you receive Rs. 1,250 (from trades 2 and 3) and pay Rs. 730 (for trades 1 and 4). This leaves you with a net gain of Rs. 520 from building the strategy alone. 

Maximum Profit and Loss from the Iron Butterfly

For the iron butterfly to be a profitable options trading strategy, the asset price at expiry must close at the middle strike price. In this case, the maximum profit from the trade will be calculated as shown below:

Maximum Profit = Net Premium Received

The maximum loss, however, occurs if the asset price closes below the lower strike or above the higher strike at expiry. If the former is true and the stock or asset closes at a price below the long put’s strike, the maximum loss will be computed as follows:

Maximum Loss = Strike Price of the Short Put — Strike Price of the Long Put — Net Premium Received

However, if the stock or asset closes above the strike price of the long call, the maximum loss will be computed as per the below formula:

Maximum Loss = Strike Price of the Long Call — Strike Price of the Short Call — Net Premium Received

Decoding the Different Outcomes of the Iron Butterfly Strategy

At expiry, the price of the underlying asset may be less volatile (as expected) or may move significantly, leading to unfavourable outcomes. Let us check out different possible scenarios and examine when this options trading strategy is profitable and when it is not. 

• Scenario 1: The Stock Closes at the Middle Strike Price at Expiry

This is the most profitable scenario. In our example, this means the stock price at expiry will be Rs. 200. In this case, all four options expire worthless, leaving you with the net credit of Rs. 520 as the profit from the trade. 

• Scenario 2: The Stock Closes Below the Lower Strike Price at Expiry

Say the stock price at expiry is Rs. 180. In this case, the call options will both expire worthless because they have higher strike prices than the current price. However, the put options will be profitable to the buyer. The outcomes from the trades can be computed as follows:

This also aligns with the results of the formula for the maximum loss, which is as follows:

Maximum Loss: 

= Strike Price of the Short Put — Strike Price of the Long Put — Net Premium Received

= [(Rs. 200 — Rs. 190) x 100 shares] — Rs. 520

= Rs. 480 

• Scenario 3: The Stock Closes Above the Higher Strike Price at Expiry

Now, say the stock price at expiry is Rs. 225. In this case, the put options will both expire worthless because their strike prices are lower than the current stock price. However, the call options will be profitable to the buyer. So, the outcomes from the trades can be computed as follows:

Again, this also aligns with the results of the formula for the maximum loss, which is as follows:

Maximum Loss: 

= Strike Price of the Long Call — Strike Price of the Short Call — Net Premium Received

= [(Rs. 210 — Rs. 200) x 100 shares] — Rs. 520

= Rs. 480 

Make Options Trading More Profitable with Samco Securities

The iron butterfly strategy is a fairly complex trade setup. To make this options trading strategy profitable, you need to analyse the possible outcomes at different asset prices, evaluate the maximum profit and loss from this trade and check what the probability of profit is. Options B.R.O, Samco’s advanced options strategy builder, can be a game changer here. 

You can access this feature free of cost in the Samco trading app. In addition to this, you can also leverage the various analytical tools and calculators offered by Samco Securities. The Samco brokerage calculator can be particularly useful if you want to understand the true cost of executing any trade in the options market. When you choose complex strategies like the iron butterfly, it may be easy to overlook the brokerage costs in favour of other outlays and inflows. 

The Samco brokerage calculator ensures that you avoid this pitfall by giving you a clear breakup of the brokerage, STT, SEBI turnover fees, stamp duty, GST, exchange transaction charges and net profit. While most such calculators offer similar data, the Samco brokerage calculator goes a step further and gives you a detailed comparison between the percentage-wise brokerage and Samco’s flat-fee brokerage per trade. You can even use the Samco brokerage calculator to check out the points to break even and plan your trades accordingly. 

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