Updated: Nov 29, 2020
SHORT IRON BUTTERFLY
Strategy Type: Neutral on the direction and bearish on volatility
# of legs: 4 (Long 1 Lower Strike Put + Short 1 Middle Strike Put + Short 1 Middle Strike Call + Long 1 Higher Strike Call)
Maximum Reward: Limited to the extent of net premium received
Maximum Risk: Middle Strike Price - Lower Strike Price - Net Premium Received
Lower Breakeven Price: Middle Strike Price - Net Premium Received
Upper Breakeven Price: Middle Strike Price + Net Premium Received
Payoff Calculation: Payoff of lower strike Long Put+ Payoff of middle strike Short Put + Payoff of middle strike Short Call + Payoff of higher strike Long Call
Explanation of the Strategy
A Short Iron Butterfly is a strategy that involves buying a lower strike Put, selling a middle strike Put and Call having the same strike price, and buying a higher strike Call. Each of these options must have the same underlying and expiration date. The lower strike Put that is bought is an OTM Put, the higher strike Call that is bought is an OTM Call, while the middle strike Put and Call that are sold are ATM options. This strategy is a combination of a Short Straddle and a Long Strangle, each of which would be discussed in the coming chapters. Meanwhile, an important thing to keep in mind when trading this strategy is that the lower and the higher strikes must be equidistant from the middle strike.
A Short Iron Butterfly is a neutral strategy in terms of direction. The trader who initiates this strategy would want the underlying price to consolidate near the middle strike price until expiration. Hence, it can be said that this strategy is bearish on volatility and benefits during times when volatility is reducing. A Short Iron Butterfly has two breakeven points: lower and upper. The position is profitable as long as the underlying price is within the breakeven points and unprofitable when the underlying price is outside the breakeven points. Both profits and losses under this strategy are limited. Maximum profit occurs when the underlying price is exactly at the middle strike, while maximum loss occurs when the underlying either falls below the lower strike or rises above the higher strike.
As Short Iron Butterfly involves buying OTM options and selling ATM options, this strategy is a net credit strategy. In terms of the risk to reward profile, a Short Iron Butterfly is quite attractive. In absolute terms, the maximum potential profit under this strategy is usually much larger than the maximum potential loss. As a result, this strategy can be initiated by intermediate option traders as well. Also, as we shall later see, Short Iron Butterfly has a similar payoff structure as a Long Call Butterfly or a Long Put Butterfly. However, there are differences. The major difference is that Long Call/Put Butterfly strategies are net debit strategies, while Short Iron Butterfly is a net credit strategy.
Benefits of the Strategy
· This is a net credit strategy
· The risk of this strategy tends to be much smaller than the potential reward
· Time decay benefits the position, as long as it is profitable
· Maximum loss under this strategy is limited
Drawbacks of the Strategy
· When the underlying price is near the middle strike, a rise in volatility would hurt the position
· If the underlying price moves outside one of the two breakeven points, the trader will incur a loss
· Ensure that you expect the underlying to remain in a range and consolidate near the middle strike
· Ensure that you have a bearish stance on volatility, and it is likely to reduce once you have initiated the position
· Ensure that the distance between the lower strike and the middle strike is equal to that between the middle strike and the higher strike
· The spread between the strikes will be a trade-off between the risk and the reward
· The wider the difference between the adjacent strikes, the higher will be the risk but so would be the reward, and vice versa
· Also, the wider the difference between the adjacent strikes, the larger would be the profit making zone, and vice versa
· As this is a range bound strategy that benefits from falling volatility, ensure that you execute this strategy when there is less time to expiration, as this would give you less time to go wrong
· Ensure there is sufficient liquidity in the underlying that is being chosen to initiate this strategy
Option Greeks for Short Iron Butterfly
GreekNotesDelta: Delta is at or near zero at the initiation. It tends to peak out above zero when the underlying price is below the lower strike and bottom out below zero when the underlying price is above the higher strike. That said, while Delta does become non-zero as the underlying price moves, it does not deviate much from zero. As such, changes in the price of the underlying do not have much impact on this strategy because of the way it is structured.
Gamma: Gamma is negative and is at its lowest point at the initiation. As the underlying price moves away from the middle strike and approaches either the lower or the higher strike, Gamma tends to move into positive before peaking out around these extreme strikes.
Vega: Vega is negative and is at its lowest point at initiation, meaning the negative impact of a rise in volatility is the highest at the middle strike. Volatility hurts as long as the position in profitable. That said, Vega turns positive when the position becomes unprofitable, meaning a rise in volatility now starts helping the position.
Theta: Theta is positive and is at its highest point at initiation, meaning time decay is most helpful around the middle strike. Time decay benefits the position as long as it is profitable. That said, Theta turns negative when the position becomes unprofitable, meaning time decay now starts hurting the position.
Payoff of Short Iron Butterfly
The above is the payoff chart of a Short Iron Butterfly strategy. Notice that the strategy is profitable as long as the underlying price is within the confines of the two breakeven point and is unprofitable when the underlying price is either below the lower breakeven or above the upper breakeven. Notice that maximum profit under this strategy occurs when the underlying price is exactly at the middle strike. This profit, however, is limited to the extent of the net premium received. On the other hand, maximum loss under this strategy occurs when the underlying price is either below the lower strike or above the higher strike. In either case, the maximum loss is limited to the extent of the difference between the two adjacent strikes less the net premium received.
Example of Short Iron Butterfly
Let us say that Mr. ABC has looked at the chart of Nifty. He is of the opinion that the index will consolidate near the current level in the short-term with falling bouts of volatility. Based on this, let us say that he has decided to initiate a Short Iron Butterfly strategy, wherein he will buy 1 OTM 9000 Put at ₹205, sell 1 ATM 9250 Put at ₹310, sell 1 ATM 9250 Call at ₹300, and buy 1 OTM 9500 Call at ₹175. Let us summarize the details of the strategy below:
· Strike price of OTM longPut = 9000
· Strike price of ATM shortPut = 9250
· Strike price of ATM shortCall = 9250
· Strike price of OTM long Call = 9500
· Long Put premium (lower strike) = ₹205
· Short Put premium (middle strike) = ₹310
· Short Call premium (middle strike) = ₹300
· LongCall premium (higher strike) = ₹175
· Net Credit = ₹230 (310 + 300 - 205 - 175)
· Net Credit (in value terms) = ₹17,250 (230 * 75)
· Lower Breakeven point = 9020 (9250 - 230)
· Upper Breakeven point = 9480 (9250 + 230)
· Maximum reward = ₹17,250
· Maximum risk = ₹1,500 ((9250 - 9000 - 230) * 75)