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Long Iron Butterfly Option Strategy

Long Iron Butterfly Option Strategy

What is Long Iron Butterfly Options Strategy?

  • Long Iron Butterfly is a four-leg options strategy created by selling an ITM put options buying ATM call and put options and selling an OTM option. All options have the same expiration and strikes are positioned to be equidistant. In Long Iron Butterfly trader expects market to show significant move either side. Long Iron butterfly is created as a net credit strategy which has limited profit potential and limited risk. Long Iron Butterfly spread will benefit from the increase in the volatility. To achieve the maximum benefit underlying must move below the lower strike price or rise above the higher strike price. Volatility is of foremost importance for the significant move. Higher the volatility, higher the probability of stock to move significantly.

When to Execute Long Iron Butterfly Options Strategy?

  • Long Iron Butterfly can be executed when, one is expecting a significant move either side, where your maximum profit occurs if the stock moved significantly up or down, profit is limited on both sides. Ideal strategy, when one is anticipating very high volatility in the stock price. Long Iron Butterfly spread should never be deployed when stock is directional either bullish or bearish, we should have a market forecast as either side, while Volatility plays its major role.

What is the Trade?

  • Long Iron Butterfly can be devised by selling One lot out -the-Money (OTM) put, buying 1 lots each At-the-Money (ATM) Calls and Put, and selling 1 lot Out-of-Money (OTM) Call of the same underlying and expiration, while the difference between the strike price should be equal i.e. the trader should select the strikes with are equidistant from ATM.

Break-Even Point for Long Iron Butterfly

  • There will be two breakeven in this Long Iron Butterfly.

    Lower Break-even Point: The lower break-even point is calculated by adding the net debit paid for the trade to the strike price of the lower strike price option. For example, if the net debit paid for the trade is Rs 75, and the strike price of the lower strike price option is Rs 17000, the lower break-even point would be 17,000 + 75 = Rs 17,075.

    Upper Break-even Point: The upper break-even point is calculated by subtracting the net debit paid from the higher strike price. For example, if the net debit paid for the trade is Rs 75, and the strike price of the upper strike price option is Rs 18,000, the upper break-even point would be 18,000 - 75 = Rs 17,925.

What will be maximum profit?

  • Long Iron Butterfly achieve the maximum profit when underlying price expires on the either of the wings of butterfly spread i.e., if it closes above or below the breakeven point Long Iron Butterfly will realised the maximum profit.

    Profit condition in short call will be achieved by following conditions.
    1. If underlying closes on lower wing of the butterfly, then Long Iron Butterfly will expire worthless i.e., all the options will become zero. So, trader will keep the net credit.
    2. If underlying closes on the higher wing of butterfly, then Short Call Butterfly will expire ITM i.e all the options will have some intrinsic value, which will make net value of butterfly zero, so trade will keep the net credit again.

What will be maximum loss?

  • Maximum Loss occur in Long Iron Butterfly when underlying fails to show the significant movement it expires around the ATM option. In this case as we bought two options, sold option will fails to compensate for it and trade will incur max at loss at the tip of the butterfly. Which can easily be calculated by subtracting ATM strike - ITM strike and adjusted for initial net credit.

What are the advantages?

  • Long Iron Butterfly is good for the stock which are oscillating for long time and having and important event down the line, which creates the uncertainty for the stock and expected to move either side because of increase in the volatility. Long Iron Butterfly spread is a net debit strategy with defined reward to risk.

    Another advantage is that this option trading strategy requires the trader to have a less amount of capital to invest, as it involves buying and selling multiple options contracts.

What are the disadvantages?

  • One disadvantage of the Long Iron Butterfly strategy is that it has limited profit potential.
    Another disadvantage is that the options strategy has a relatively high breakeven point, meaning that the underlying asset would need to move a significant amount before the trader begins to make a profit.
    Additionally, this option trading strategy is sensitive to changes in volatility, meaning that if volatility decreases, the value of the options will decrease, which can lead to losses for the trader.
    Finally, like other options strategies, the Long Iron butterfly options strategy also has a limited lifespan, as options expire at a certain date, so the trader needs to be aware of that expiration date and close the position before it expires.

Example of Long Iron Butterfly:

  • Nifty future price is 15700. A Short Iron Butterfly can be devised as follows -1 X 16000 CE = 160 +1 X 15700 CE= 304.00 +1 X 15700 PE = 260.00 -1X 15400 PE = 155.00 Net Premium Paid or Received = Rs. (-249.00) Maximum Defined Loss at 15700. Profit is defined below or above 15450.00—15950.00