Reverse Iron Butterfly Explained

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Iron Butterfly

What is an Iron Butterfly?

An iron butterfly is an options trade that uses four different contracts as part of a strategy to benefit from stocks or futures prices that move within a defined range. The trade is also constructed to benefit from a decline in implied volatility. The key to using this trade as part of a successful trading strategy is forecast a time when option prices are likely to decline in value generally. This usually occurs during periods of sideways movement or a mild upward trend. The trade is also known by the nickname “Iron Fly.”

Key Takeaways

  • Iron Butterfly trades are used as a way to profit from price movement in a narrow range during a period of declining implied volatility.
  • The construction of the trade is similar to that of a short-straddle trade with a long call and long put option purchased for protection.
  • Traders need to be mindful of commissions to be sure they can use this technique effectively in their own account.
  • Traders need to be aware that his trade could lead to a trader acquiring the stock after expiration.

How an Iron Butterfly Works

The Iron Butterfly trade is created with four options consisting of two call options and two put options. These calls and puts are spread out over three strike prices, all with the same expiration date. The goal is to profit from conditions where the price remains fairly stable and the options demonstrate declining implied and historical volatility.

It can also be thought of as a combined option trade using both a short straddle and a long strangle, with the straddle positioned on the middle of the three strike prices and the strangle positioned on two additional strikes above and below the middle strike price.

The trade earns the maximum profit when the underlying asset closes exactly on the middle strike price on the close of expiration. A trader will construct an Iron Butterfly trade with the following steps.

  1. The trader first identifies a price at which they forecast the underlying asset will rest on a given day in the future. This is the target price.
  2. The trader will use options which expire at or near that day they forecast the target price.
  3. The trader buys one call option with a strike price well above the target price. This call option is expected to be out-of-the-money at the time of expiration. It will protect against a significant upward move in the underlying asset and cap any potential loss at a defined amount should the trade not go as forecast.
  4. The trader sells both a call and a put option using the strike price nearest the target price. This strike price will be lower than the call option purchased in the previous step and higher than the put option in the next step.
  5. The trader buys one put option with a strike price well below the target price. This put option is expected to be out-of-the-money at the time of expiration. It will protect against a significant downward move in the underlying asset and cap any potential loss at a defined amount should the trade not go as forecast.

The strike prices for the option contracts sold in steps two and three should be far enough apart to account for a range of movement in the underlying. This will allow the trader to be able to forecast a range of successful price movement as opposed to a narrow range near the target price.

For example, if the trader thinks that, over the next two weeks, the underlying could land at the price of $50, and be within a range of five dollars higher or five dollars lower from that target price, then that trader should sell a call and a put option with a strike price of $50, and should purchase a call option at least five dollars higher, and a put option at least five dollars lower, than the $50 target price. In theory, this creates a higher probability that the price action can land and remain in a profitable range on or near the day that the options expire.

Deconstructing the Iron Butterfly

The strategy has limited upside profit potential by design. It is a credit-spread strategy, meaning that the trader sells option premiums and takes in a credit for the value of the options at the beginning of the trade. The trader hopes that the value of the options will diminish and culminate in a significantly lesser value, or no value at all. The trader thus hopes to keep as much of the credit as possible.

The strategy has defined risk because the high and low strike options (the wings), protect against significant moves in either direction. It should be noted that commission costs are always a factor with this strategy since four options are involved. Traders will want to make certain that the maximum potential profit is not significantly eroded by the commissions charged by their broker.

The Iron butterfly trade profits as expiration day approaches if the price lands within a range near the center strike price. The center strike is the price where the trader sells both a call option and a put option (a short strangle). The trade diminishes in value as the price drifts away from the center strike, either higher or lower, and reaches a point of maximum loss as the price moves either below the lower strike price or above the higher strike price.

Iron Butterfly Trade Example

The following chart depicts a trade setup that implements an Iron Butterfly on IBM.

In this example the trader anticipates that the price of IBM shares will rise slightly over the next two weeks. The company released its earnings report two weeks previous and the reports were good. The trader believes that the implied volatility of the options will generally diminish in the coming two weeks, and that the share price will drift higher. Therefore the trader implements this trade by taking in an initial net credit of $550 ($5.50 per share). The trader will make a profit so long as the price of IBM shares moves in between 154.50 and 165.50.

If the price stays in that range on the day of expiration, or shortly before it, the trader can close the trade early for a profit. The trader does this by selling the call and put options that were previously purchased, and buying back the call and put options that were sold at the initiation of the trade. Most brokers allow this to be done with a single order.

An additional trading opportunity available to the trader occurs if the price stays below 160 on the day of expiration. At that time the trader can let the trade expire and have the shares of IBM (100 per put contract sold) put to them for the price of $160 per share.

For example, suppose the price of IBM closes at $158 per share on that day, and assuming the trader lets the options expire, the trader would then be obligated to buy the shares for $160. The other option contracts all expire worthless and the trader has no need to take any action. This may seem like the trader has simply made a purchase of stock at two dollars higher than necessary, but remember, the trader took in an initial credit of $5.50 per share. That means the net transaction can be seen differently. The trader was able to purchase shares of IBM and collect $2.50 profit per at the same time ($5.50 less $2.00).

Most of the effects of the Iron Butterfly trade can be accomplished in trades that require fewer options legs and therefore generate fewer commissions. These include selling a naked put or buying a put-calendar spread, however the Iron Butterfly provides inexpensive protection from sharp downward moves that the naked put does not have. The trade also benefits from declining implied volatility, which the put calendar spread cannot do.

What Is an Iron Butterfly Option Strategy?

Options offer many strategies to make money that cannot be duplicated with conventional securities and not all types of option trading are high-risk ventures. For example, the iron butterfly strategy can generate steady income while setting a dollar limit on the profit or loss.

What Is an Iron Butterfly?

The iron butterfly strategy is a member of a specific group of option strategies known as “wingspreads” because each strategy is named after a flying creature like a butterfly or condor. The strategy is created by combining a bear call spread with a bull put spread with an identical expiration date that converges at a middle strike price. A short call and put are both sold at the middle strike price, which forms the “body” of the butterfly, and a call and put are purchased above and below the middle strike price, respectively, to form the “wings”.

This strategy differs from the basic butterfly spread in two respects. First, it is a credit spread that pays the investor a net premium at open while the basic butterfly position is a type of debit spread. Second, the strategy requires four contracts instead of three.

For example, ABC Company has rallied to $50 in August and the trader wants to use an iron butterfly to generate profits. He or she writes both a September 50 call and put, receiving $4.00 of premium for each contract, and also buys a September 60 call and September 40 put for $0.75 each. The net result is an immediate $650 credit after the price paid for the long positions is subtracted from the premium received for the short ones ($800-$150).

Premium received for short call and put = $4.00 x 2 x 100 shares = $800

Premium paid for long call and put = $0.75 x 2 x 100 shares = $150

$800 – $150 = $650 initial net premium credit

How to Use the Iron Butterfly

Iron butterflies limit both the possible gain and loss. They are designed to allow traders to keep at least a portion of the net premium that is initially paid, which happens when the price of the underlying security or index closes between the upper and lower strike prices. Market players use this strategy when they believe the underlying instrument will stay within a given price range through the options’ expiration date. The nearer to the middle strike price the underlying closes at expiration, the higher the profit.

The trader will incur a loss if the price closes either above the strike price of the upper call or below the strike price of the lower put. The breakeven point can be determined by adding and subtracting the premium received from the middle strike price.

In the previous example, the breakeven points are calculated as follows:

Middle strike price = $50

Net premium paid upon open = $650

Upper break-even point = $50 + $6.50 (x 100 shares = $650) = $56.50

Lower break-even point = $50 – $6.50 (x 100 shares = $650) = $43.50

If the price rises above or below the breakeven points, the trader will pay more to buy back the short call or put than received initially, resulting in a net loss.

Let’s say ABC Company closes at $75 in November, which means all of the options in the spread will expire worthless except for the call options. The trader must therefore buy back the short $50 call for $2,500 ($75 market price – $50 strike price x 100 shares) in order to close out the position and is paid a corresponding premium of $1,500 on the $60 call ($75 market price – $60 strike price = $15 x 100 shares). The net loss on the calls is, therefore, $1,000, which is then subtracted from the initial net premium of $650 for a final net loss of $350.

Of course, it is not necessary for the upper and lower strike prices to be equidistant from the middle strike price. Iron butterflies can be created with a bias in one direction or the other, where the trader believes the underlying will rise or fall slightly in price but only to a certain level. If the trader believes ABC Company will rise to $60 by expiration, they can raise or lower the upper call or lower put strike prices accordingly.

Iron butterflies can also be inverted so that long positions are taken at the middle strike price while short positions are placed at the wings. This can be done profitably during periods of high volatility in the underlying instrument.

Advantages and Disadvantages

Iron butterflies provide several key benefits. They can be created using a relatively small amount of capital and provide steady income with less risk than directional spreads. They can also be rolled up or down like any other spread if price begins to move out of the range or traders can choose to close out half of the position and profit on the remaining bear call or bull put spread. The risk and reward parameters are also clearly defined. The net premium paid is the maximum possible profit the trader can reap from this strategy and the difference between the net loss between the long and short calls or puts minus the initial premium paid is the maximum possible loss the trader can incur.

Watch commission costs on iron butterflies because four positions must be opened and closed, and the maximum profit is seldom earned because the underlying will usually settle between the middle strike price and either the upper or lower limit. In addition, the chances of incurring a loss are proportionately higher because most iron butterflies are created using fairly narrow spreads,

The Bottom Line

Iron butterflies are designed to provide traders and investors with steady income while limiting risk. However, this type of strategy is only appropriate after thoroughly understanding the potential risks and rewards. Most brokerage platforms also require clients who employ this or similar strategies to meet certain skill levels and financial requirements.

Reverse Iron Condor Strategy

The Reverse Iron Condor (RIC) is a limited risk, limited profit trading strategy that is designed to earn a profit when the underlying stock price makes a sharp move in either direction. The RIC Spread is where you buy an Iron Condor Spread from someone who is betting on the underlying stock staying stagnant.

Introduction

Reverse Iron Condor Construction

  • Buy 1 OTM Put
  • Sell 1 OTM Put (Lower Strike)
  • Buy 1 OTM Call
  • Sell 1 OTM Call (Higher Strike)

Reverse Iron Condor has a limited gain and a limited loss potential. The maximum gain It is attained when the underlying stock price drops below the strike price of the short put or rise above or equal to the higher strike price of the short call. In either situation, maximum profit is equal to the difference in strike between the calls (or puts) minus the net debit taken when initiating the trade. It will result in a loss if the price doesn’t move far enough in either direction, or if it stays the same.

Compared to a straddle option strategy, RIC has limited gain potential, but it also needs the stock to move less to be profitable. It is basically a combination of bull call debit spread and bear put debit spread. You can adjust the strikes based on your expectation of the move. Constructing the trade with further OTM options will provide a better risk/reward, but lower probability of success (the stock will need to move more to produce a gain).

One of the common uses of the Reverse Iron Condor strategy is betting on a sharp move on one of the high flying stocks after earnings. It can be used on stocks like NFLX, AMZN, GOOG, TSLA, PCLN etc.

Using Reverse Iron Condor through Earnings

GOOG was scheduled to report earnings on April 21, 2020. The At-The-Money weekly straddle ($760 strike) was trading around $41, implying $41 or 5.3% move.

If you believed that GOOG is going to move, you had two options:

Option #1: buy a straddle for $41 debit

  • Buy 1 760 Put
  • Buy 1 760 Call

Option #2: buy RIC (Reverse Iron Condor) for 1.75 debit

  • Buy 1 745 Put
  • Sell 1 740 Put (Lower Strike)
  • Buy 1 775 Call
  • Sell 1 780 Call (Higher Strike)

Straddle would need $41 move just to break even, but would have unlimited profit potential if the stock moved big time. It also would not lose as much if the stock moved less than expected.

RIC would need only $20 move (above $780 or below $740) to make money.

The next day GOOG moved $40 and closed at $719. Since it was below the short put strike, the RIC made a nice 43% gain (2.50/1.75), while the straddle was barely breakeven.

The Risks

The biggest drawdown of the RIC strategy before earnings is that if the stock doesn’t move enough after earnings, IV collapse will crush the options prices. The risk of 80-100% loss is real.

Unfortunately, many options gurus present this strategy as almost risk free money, completely ignoring the risks. Here are two examples.

A Seeking Alpha contributor suggested the following play on GOOG earnings on April 12, 2020 with GOOG at $632:

  • Buy twenty (20) April Week 2 $610.00 put options
  • Sell twenty (20) April Week 2 $600.00 put options
  • Buy twenty (20) April Week 2 $650.00 call options
  • Sell twenty (20) April Week 2 $660.00 call options

Rationale behind the trade:

“Google is a notorious big-mover after reporting. I am completely confident that the trade recommendation I am writing about will work like a charm.

What is completely missing in this comment is the disclosure of the options trading risk. The next day GOOG closed at $624, and the trade has lost 100%.

As our contributor Chris (cwelsh) mentioned in the comments section:

“Earnings are wild and unpredictable. A careful analysis and you can improve your odds, but you always have to factor in position sizing and potential loss into any trade. My entire point of my posts was that I think a discussion of risks should always be included in any article that discusses huge potential gains.”

I recommend reading the comments section of the article, it can tell a lot about different people’s approaches to trading and risk.

The second example is from a website that is using the strategy cycle after cycle. Here is the quote:

“The Debit Iron Condor is used primarily on stocks that have a long history of big moves when announcing their quarterly earnings. We have a very good idea of how big the move will be, in one direction or the other. And the amazing thing about studying history is that history truly repeats itself, and that means a big percentage of wins. The magic works when the Debit Iron Condor is combined with big moves from stocks on earnings day.”

The problem is, once again, complete lack of disclosure of the option trading risk. Even if the “history truly repeats itself” 80% of the time, in 20% of the cases when it doesn’t, the strategy can lose 100%. Big percentage of wins means nothing if your losers are much higher than the winners, and you can do nothing to control the losers due to IV collapse.

One way to reduce the risk is using more distant expiration instead of the weekly options. The closer the expiration, the bigger the impact on trade. There is a trade off with respect to time, move and implied volatility drop. If the stock doesn’t move, the further expiration trade will lose less because there still will be some time value left. On the other hand, if it does move, the gains will be less as well, and you will have to wait longer to realize the full potential.

Unfortunately, we tried this strategy too in 2020, and the results were pretty bad. You can read more here. We don’t hold those trades through earnings anymore, but we do use the strategy before earnings and make sure to be before the earnings announcement.

The Bottom Line

If you expect a stock to move significantly but don’t want to bet on direction, Reverse iron Condor is a good strategy to implement. The maximum profit and the maximum loss are both predictable, and you can adjust the strikes based on your expectation how much you the price will move.

This strategy can be successfully used for trading stocks with history of big moves. GOOG, NFLX, AMZN, TSLA, BIIB are good candidates. However, earnings are unpredictable, and you need to control the risk with proper position sizing. It is definitely possible to lose 100% with this strategy. I would define it as high probability high risk strategy.

One of the members asked me on the forum if we are going to play GOOG and AMZN with RIC. Based on earnings uncertainty and our bad experience earlier this year, I decided to skip. It was a good call. GOOG RIC would be a 100% loser, and AMZN would be a borderline as well, depending on the strikes.

Want to learn more? We discuss all our trades on our forum.

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