There are many possible options trading strategies. One of these, the iron butterfly, consists of four separate option contracts distributed across three separate strike prices. Luckily these contracts are for the same underlying stock and the same expiration date, but the strategy is complex enough to be somewhat difficult to understand not to mention set up for those new to options trading. So, why use an iron butterfly options strategy? This approach is typically used when volatility is low in neutral markets. Traders must learn when this trade is appropriate as well as when and how to exit the trade.
You can think of an iron butterfly as a short straddle with an added long put and long call which is a long strangle. The iron part refers to the strong likelihood of making a small profit and the butterfly refers to the spread of the strike prices from high to low. One important aspect of the iron butterfly is that while it protects you against losses it promises only a small gain. Thus, traders need to make certain that commissions and fees do not routinely eat up profit potential with this approach.
The first part is choosing this trade when implied volatility is likely to fall. Then the trader needs to choose the three strike prices. The maximum profit with this strategy happens when the underlying stock closes at exactly the same price as the middle strike price. Thus you will start by choosing a target price for where you believe the stock will close on a given future date. Then you will choose options contracts that expire on or near that date. Purchase a call option with a strike price higher than your target price and purchase a put option at a strike price lower than the target price. Sell a call and a put near or at the middle strike price. This setup will generate an initial credit which will decrease as the stock price closes farther above or below your target price.
Your call option purchased at the top price in this spread protects against loss should the underlying stock go far above the current trading range and the put option purchased at the bottom price of the spread protects against loss should the price of the underlying fall precipitously. There is skill involved in choosing how far above and below the target price you set your purchased call and put. You can increase the initial credit of the trade by choosing prices that are more distant and protect yourself from loss by choosing prices that are closer to the target price.
The initial credit is determined by the premiums earned for the sold call and put minus the premiums paid for the purchased call and put minus four separate sets of commissions and fees. For many traders the main drawback for this trade is the “overhead” of setting up a trade with four separate contracts and four separate sets of fees and commissions.
This is one of the many options trades you can choose when you expect the market to trade sideways with decreasing volatility. You are choosing to accept a small profit in return for minimal risk. There is, however, never a situation in which there is no risk. As such, like all trades, you need to pay attention and consider getting out with a reduced profit should something unexpected roil the market and drive prices significantly higher or lower. One of the benefits of joining a trading squadron at Maverick Options is that you will learn how to pick and choose this sort of trade, how to set it up, and when as well as how to get out if necessary.