Mar

2

Iron Butterfly

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No, I’m not talking about the 1960’s psychedelic rock band. I’m talking about a modification of the popular option spread-the Butterfly.
 
The Iron Butterfly Spread belongs to the family of complex stock option spread strategies like the Condor Spread, Butterfly Spread and Iron Condor Spread. Each of them has their own strengths and weaknesses.
 
The Iron Butterfly is normally used when an option trader expects the price of the underlying asset to change very little over the life of the option. One way that the Iron Butterfly Spread differs from the Butterfly Spread is that the Iron Butterfly Spread initially results in a net credit whereas executing a Butterfly Spread results in a net debit. There is also a variation in the middle or body portion of the spread.
 
In the more common Butterfly spread, the body (situated at the mid-strike price) is normally either two sold calls or puts. In the case of an Iron Butterfly, the body is made up of one call and one put. This strategy helps to limits the amount of risk and reward for the option spread because of the offsetting long and short positions. If the price falls dramatically and the investor holds a short straddle at the center strike price, the position is protected because of the lower long put option.  Conversely, when the price of the stock rises, the investor is protected by the upper long call option.
 
In effect, the Iron Butterfly Spread actually consists of a Bear Call Spread (purchase an At-The-Money or Out-of-The-Money call option and simultaneously writing (selling) an In-The-Money or At-The-Money call option on the same underlying and same expiration month.) and a Bull Put Spread.
 
Iron Butterfly:
 Buy OTM Put + Sell ATM Call + Sell ATM Put+ Buy OTM Call
 
Current IBM: $104
B/S
C/P
SP
Premium
$
B (1)
P
100
.50
($50)
S (1)
C
105
3.35
$435
S(1)
P
105
3.10
$310
B (1)
C
110
.50
($50)
 
 
 
 Credit
$645
 
 
 
Iron Butterfly Math
Breakeven:
Lower : Short Put Strike –   Net Credit = $105 – $4.45 = $100.55
Upper: Short Call Strike + Net Credit = $105 + $4.45= $109.45
 
Maximum Risk: Difference in strikes-Net Credit= $5-$4.45= .55 or $55
Maximum Profit: If IBM price expires at 105= $445
Estimated Commissions $20
Net before tax= $425
Less cap gains Taxes: $ 148.75
Net after tax: $276.25
Max Return: Net Credit ÷ Maximum risk= $276.25/$55= approx 500%
 

Keep in mind that maximum profit happens  if at expiration the price of the stock is ATM for the middle strike price.

Mar

1

Butterfly Math

Filed Under Option Trading Articles | Leave a Comment

Man, was I turned around. That’s part of the problem of being self taught. Call it arrogance or call it penuriousness. Butterflies are beautiful, but only if you can understand what you are seeing. I had a butterfly turn into a caterpillar because I didn’t understand about butterfly math.
As you may recall, a butter fly can be long or short. A long call butterfly spread consists of three legs with a total of four options: long one in-the-money call with a lower strike, short two calls as close to at-the-money as possible with a middle strike and long one out-of- the-money call at a higher strike. All the options are in the same expiration moth, and the middle strike is halfway between the lower and the higher strikes. The position is considered "long" the ITM option is a long call position. This position is a debit spread because it requires a net cash outlay to initiate. For our purpose, we will consider the long Butterfly.
IBM: Current Price $104
B/S
C/P
SP
Premium
$
B (1)
C
100
4.50
($450)
S (2)
C
105
2.35 @
$$470
B (1)
C
110
.50
($50)
 
 
 
Net cost
($30)
 
Butterfly Math
Breakeven: To determine the profit price range, we first need to figure breakeven from the lower Strike price: add the net debit to the ITM call. In this case it would be $100 + .30 or 100.30.
Now we need to figure the breakeven for the upper strike price: Subtract the net debit from the Upper Strike price: $110-.30 or $109.70. There fore the profit range is between $100.30 and $109.70.
Maximum Risk: The Net Debit. In their case $30
Maximum profit potential: The highest profit potential is found at the intermediate strike price of $105. If at expiration, IBM expires at $105, it would be $105-$100.30 or $470. Not bad for a $30 investment!
Let’s say in our example, the position expires and the Price of IBM is $103. In this case, the position would produce a profit of $103-$100.30 or $ 270 for a still impressive 900% ROI! However, commissions and any other transaction costs must be deducted for the net gain. And then, taxes also need to be deducted. Consider a capital gains tax of 35% and commission charge of $15, this would leave a net, net of  $160.50 for an ROI net net of 535%. Still not too bad!
While it’s obvious that ROI is impressive, this strategy of premium capture requires patience and perseverance. It’s not a get rich quick strategy but it can be most appropriate for capital conservation and long term growth.
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