Accurately predicting price trends can be a challenge. Fortunately, options trading offers a unique advantage: the ability to profit from low price volatility. The Iron Butterfly strategy is a prime example of this approach, as it can generate profits when stock prices are not trending strongly.
Simply put, the Iron Butterfly is a way to make money when the market is quiet. And in this blog post, we’ll delve into the specifics of this strategy, including which stocks are best suited for it and how to find the most promising Iron Butterfly trading opportunities.
What is an Iron Butterfly?
Essentially, with the Iron Butterfly strategy, you sell a call and put option at the same strike price and expiration date, while also buying a call and put option with the same expiration date but at a higher and lower strike price respectively. This creates a position that is profitable if the underlying asset’s price stays within a certain range.
The advantage of this strategy is that it limits your risk exposure while allowing you to earn a net credit, which is the difference between the premiums received and paid for the options. However, it’s important to note that the net credit received is also your maximum profit.
On the other hand, the maximum potential loss is also limited to the difference between the strike prices of the two call (or put) options, minus the net credit received.
Iron Butterfly Trade Example
Let me explain the Iron Butterfly trading strategy using an example of trading on Apple’s stock.
Current stock price: $150
Options Expiration date: one month from today
Total premium received for selling call and put options: $600
Total premium paid for buying call and put options: $100
Sell 1 AAPL $150 call option at a premium of $3.00 (total premium received: $300)
Sell 1 AAPL $150 put option at a premium of $3.00 (total premium received: $300)
Buy 1 AAPL $160 call option at a premium of $0.50 (total premium paid: $50)
Buy 1 AAPL $140 put option at a premium of $0.50 (total premium paid: $50)
Now, let’s understand why the trader has chosen this strategy. The trader believes the stock market might perform poorly due to the Federal Reserve’s monetary tightening policy. However, the trader is confident that Apple’s stock can withstand some interest rate effects and stay stable. But the possibility of the stock price increasing is also low due to macroeconomic factors.
As the Federal Reserve just concluded its rate policy meeting a few days ago, the trader believes that the implied volatility of the options will gradually decrease in the next two weeks, and the stock price will remain flat. Therefore, the trader implements the Iron Butterfly strategy and receives a total of $500 ($5 per share) in option premiums (the trader earns $600 from selling options and spends $100 on buying options).
The trader can make a profit as long as Apple’s stock price fluctuates between $145 and $155. If the stock price remains in this range on or before the expiration date, the trader can close the trade early and make a profit. To do so, the trader can sell the call and put options bought earlier, and buy back the call and put options sold initially.
What if the stock price is still below $150 on the expiration date? Well, the trader has another option. They can choose not to close the trade and instead let it expire. In that case, the trader must buy Apple’s stock at $150 per share (as the sold put option would be exercised), even if the closing price is lower.
For instance, if the stock’s closing price on the expiration date is $147, the trader would have to buy the stock at $150. Although it may seem like the trader paid $3 extra per share, remember that the initial credit was $5. Thus, the trader would still make a profit of $2 per share or $200 overall.
Iron Butterfly vs Iron Condor
Essentially, Iron Butterfly and Iron Condor are two similar options trading strategies that differ in the price range of the strike prices used. And the difference in strike prices determines the profits and risks associated with each strategy.
For example, if you want to use Iron Butterfly on a stock trading at $150 per share, you would sell a call and put option with a strike price of $150, and buy a call option with a strike price of $160 and a put option with a strike price of $140.
Meanwhile, for Iron Condor, you would sell a call option with a strike price of $155, a put option with a strike price of $145, then buy a call option with a strike price of $160 and a put option with a strike price of $140.
Iron Butterfly is a high-risk, high-reward strategy. The sold options’ strike prices are close to or at the asset’s current price, resulting in higher option premiums than the Iron Condor. The maximum profit for both strategies is the premiums received. Thus, Iron Butterfly has a higher potential return. However, its closer strike prices result in a smaller profit range and higher risk.
On the other hand, Iron Condor is a lower-risk strategy as it creates a larger profit protection network by setting a larger option strike price gap. Although the maximum profit is smaller, the likelihood of making a profit is higher.
Best Stocks for Iron Butterfly
The Iron Butterfly option strategy earns money from implied volatility. Implied volatility estimates how much a stock’s price is expected to fluctuate in the future. The higher the implied volatility, the more expensive an option is. By selling options with high implied volatility, you can earn more premium income with the Iron Butterfly strategy.
In fact, implied volatility can sometimes be exaggerated, especially before key data releases. This actually benefits the option seller, as they can collect more premium income than the stock’s actual volatility warrants. That’s why it’s important to look for stocks with low implied volatility during normal times, but with a significant increase in implied volatility at present.
One of the best stocks for Iron Butterfly is the component stocks of the Dow Jones Index. Companies like Johnson & Johnson, McDonald’s, and Coca-Cola are considered value stocks, which tend to have lower volatility. However, if their implied volatility suddenly spikes, it could be a good time to use the Iron Butterfly strategy.
Tips on Trading Iron Butterfly
Choosing Suitable Expiration Date
When using this strategy, selecting options with at least one month until their expiration date is best. This is a safer approach to gain from the time value decay of the options. Additionally, options with a longer time until expiration have a higher premium, which means selling them can result in more credit and greater potential profit.
However, it’s essential to avoid choosing options with an excessively long time until expiration, as this can negatively impact the strategy’s effectiveness. If options have a long way to go before expiration, the income from time value decay will decrease.
Furthermore, it’s best to exit the Iron Butterfly strategy and roll over it when it generates a certain profit. Options with a long time until expiration will result in fewer rolls of the Iron Butterfly strategy in the future, leading to lower income.
Avoiding Impending News Stocks
Be sure to avoid stocks that are about to release information in the near future. The release of information can cause significant fluctuations in stock prices, which is detrimental to the Iron Condor strategy.
As a trader, your goal is to sell options with strike prices that you hope the final stock price will fall between. If the stock price moves beyond the strike price of the options you bought, you will suffer maximum losses.
Selecting Large-Cap Stocks
When choosing stocks, it’s good to go for those with larger market capitalization. They’re less likely to be manipulated or experience sudden large fluctuations. If you’re using the Iron Butterfly strategy, lower volatility is ideal.
Another advantage of stocks with larger market capitalization is that they usually have better liquidity for their options. The bid-ask spreads for their options are lower, so you can save on trading costs. When using the Iron Condor strategy, which involves trading four options simultaneously, lowering costs can significantly impact your returns.
Balancing Profit and Risk
The profit diagram of an iron butterfly strategy has a peak at the center, which represents the maximum profit point. To achieve this maximum profit, the position should expire at the strike price of the sold option.
To increase your maximum profit, consider buying options with strike prices that are further away from the current market price, as those options are cheaper. However, keep in mind that high returns also mean high risk. If you buy those deep-out-of-money options, your maximum loss will increase. This is because the maximum loss equals the difference between the strike prices of the two call (or put) options.
Therefore, it’s crucial to choose strike prices that are not too far from the current market price and to consider the overall risk-reward ratio.
Starting with Small
When it comes to the Iron Butterfly strategy, it’s essential to keep things simple. Implementing such a strategy requires a combination of four options, which can be time-consuming and labor-intensive. As a result, managing too many positions can be challenging and lead to mistakes that may result in losses.
To avoid this, you can start with a few positions and gradually increase the number of contracts once you become familiar with the strategy.