The Iron Butterfly: Can It Fly?
The curiously-named "iron butterfly" is a complex strategy offering limited losses and limited profits.
It is an expanded version of the basic butterfly (two separate spreads offsetting one another). The "iron" version is a combined straddle consisting of four options instead of the butterfly's three.
An iron butterfly can be either long or short. The long version consists of a long call and long put at the same strike; and a lower short put plus higher short call. For example, Dominion Resources (NYSE: D) closed on April 24, 2012 at $50.81. At that price a long iron butterfly could be created with the following contracts:
- Long 50 call @ 1.12
- Long 50 put @ 0.40
- Short 47.50 put @ 1.65
- Short 52.50 call @ 0.10
- Net credit = 0.23
For $23 (which just about covers the cost of these positions) the long iron butterfly creates a limited loss zone in the middle as well as a limited profit zone above or below. The offsets between long and short are what limit both profit and loss potential.
In a short iron butterfly, the positions are reversed; a limited middle profit zone is offset by limited loss zones above and below. For example Starbucks (NASDAQ: SBUX) closed on April 24, 2012 at $58.05. A short iron butterfly could have been constructed with the following:
- Short 60 put @ 3.23
- Short 60 call @ 1.21
- Long 57.50 put @ 1.88
- Long 62.59 call @ 0.59
- Net credit 1.97
In this case, you get $197 paid to you before trading fees. For some traders, the limits on both profit and loss are advantageous. However, this strategy does tie up margin as well as capital, and the farther away expiration is, the longer this applies. So the question should be whether this strategy is worth the limitations.
If you are not sure about the current volatility of the market, an iron butterfly is a play that could make sense, long or short depending on which direction you believe the underlying is most likely to move, and to what degree.
Swing traders might also find iron butterflies attractive in some instances, although these traders are more likely to use single option contracts or synthetics to play the swings while holding down risk exposure.
The key to this, as with other complex strategies, is timing for implied volatility ("IV"). This is where skill comes into the picture. Even the best strategy works well only if timed properly; and IV is the key. A volatility-based strategy can be complex without help, but it can be simple and easy with the right tracking tools. To improve your option trade timing, check the Benzinga service Options & Volatility Edge which is designed to help you improve selection of options as well as timing of your trades.
(c) 2013 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.