Long Iron Butterfly

 

Description

 

The Long Iron Butterfly is an intermediate strategy that can be profitable for stocks that are rangebound. It is, in fact, the combination of a Bull Put Spread and a Bear Call Spread. The higher strike put shares the same strike as the lower strike call to create the butterfly shape.

 

The combination of two income strategies also makes this an income strategy. Often, traders will leg into the Long Iron Butterfly, first trading a Bull Put Spread just below support and then as the stock rebounds off resistance adding a Bear Call Spread, thereby creating the Long Iron Butterfly.

 

Ideally the stock will remain between the lower and higher strikes, with the maximum profit occurring if the options expire when the stock is priced at the central strike price. In this ideal scenario, effectively all the options expire worthless, and you just keep the combined net credit. The combined net credit serves to widen the area of your breakevens in other words, the Bull Put element helps the Bear Call element, and vice versa.

 

Market Opinion

 

Direction neutral. You are expecting little movement in the stock price.

 

P/L

 

 

 

 

 

 

When To Use

 

Use this income strategy when you expect little movement in the stock price, where you earn maximum profit when the stock finished mid strikes.

 

Example

 

XXXX is trading at $25 on April 11, 2011.

Buy May 2011 20 strike put for $0.30.

Sell May 2011 25 strike put for $1.50.

Sell May 2011 25 strike call for $2.00.

Buy May 2011 30 strike call for $0.50.

 

Benefit

 

The benefit is, for low cost, you can make a capital gain from a rangebound stock with capped risk.

 

Risk vs. Reward

 

The risk is the difference between two strikes minus your net credit. The reward is the net credit.

 

Net Upside

 

Net credit you received.

 

Net Downside

 

The difference between adjacent strikes minus net credit.

 

Break Even Point

 

Break even up: middle strike plus net credit.

 

Break even down: middle strike minus net credit.

 

Effect Of Volatility

 

Any increased volatility would have a negative effect on this position.

 

Effect Of Time Decay

 

Positive effect when the trade is profitable, and negative effect when it is not profitable. The stock price is in a profitable zone when you buy it, so from then onwards time decay has a negative effect.

 

Alternatives Before Expiration

 

You can unravel this position before expiration in two-leg segments.

 

Close out at any time by buying back the options sold and selling the options bought.

 

Alternatives After Expiration

 

Close out the position.