Long Iron Butterfly Options Strategy
17 Apr 2017
Nilesh Jain
New Page 1
A Long Iron Butterfly is implemented when an investor is expecting
volatility in the underlying assets. This strategy is initiated to capture the movement
outside the wings of options at expiration. It is a limited risk and a limited reward
strategy. A Long Iron Butterfly could also be considered as a combination of bull call
spread and bear put spread.
When to initiate a Long Iron Butterfly
A Long Iron Butterfly spread is best to use when you expect the
underlying assets to move sharply higher or lower but you are uncertain about direction.
Also, when the implied volatility of the underlying assets falls unexpectedly and you
expect volatility to shoot up, then you can apply
Long Iron Butterfly strategy.
How to construct a Long Iron Butterfly?
A Long Iron Butterfly can be created by buying 1 ATM call, Selling 1
OTM call, buying 1 ATM put and selling 1 OTM put of the same underlying security with the
same expiry. Strike price can be customized as per the convenience of the trader; however,
the upper and lower strike must be equidistant from the middle strike.
Strategy

Buy 1 ATM Call, Sell 1 OTM Call, Buy 1
ATM Put and Sell 1 OTM Put

Market Outlook

Movement above the highest or lowest
strike

Motive

Profit from movement in either
direction

Upper Breakeven

Long Option (Middle) Strike price + Net Premium Paid

Lower Breakeven

Long Option (Middle) Strike price  Net Premium Paid

Risk

Limited to Net
Premium Paid

Reward

Higher strikemiddle strikenet premium
paid

Margin required

Yes

Let’s try to understand with an example:
Nifty Current spot price (Rs)

9200

Buy 1 ATM call of strike price (Rs)

9200

Premium paid (Rs)

70

Sell 1 OTM call of strike price (Rs)

9300

Premium received (Rs)

30

Buy 1 ATM put of strike price (Rs)

9200

Premium paid (Rs)

105

Sell 1 OTM put of strike price (Rs)

9100

Premium received (Rs)

65

Upper breakeven

9280

Lower breakeven

9120

Lot Size

75

Net Premium Paid (Rs)

80

Suppose Nifty is trading at 9200. An investor Mr
A thinks that Nifty will move drastically in either direction, below lower strike or above
higher strike by expiration. So he enters a Long
Iron Butterfly by buying a 9200 call strike price at Rs 70, selling 9300 call for Rs 30 and simultaneously buying 9200
put for Rs 105, selling 9100 put for Rs 65. The net premium paid to
initiate this trade is Rs 80, which is also the maximum possible loss.
This strategy is initiated with a view of movement in the underlying security outside the wings of higher and lower strike price
in Nifty. Maximum profit from the above example would be Rs 1500 (20*75). Maximum loss
will also be limited up to Rs 6000 (80*75).
For the ease of understanding of the payoff, we did not take in to
account commission charges. Following is the payoff chart and payoff schedule assuming
different scenarios of expiry.
The Payoff chart:
The Payoff Schedule:
On Expiry NIFTY closes
at

Net Payoff from 1 ITM
Call Bought (Rs) 9200

Net Payoff from 1 OTM
Call Sold (Rs) 9300

Net Payoff from 1 ATM
Put bought (Rs) 9200

Net Payoff from 1 OTM
Put sold (Rs.) 9100

Net Payoff (Rs)

8800

70

30

295

235

20

8900

70

30

195

135

20

9000

70

30

95

35

20

9100

70

30

5

65

20

9120

70

30

25

65

0

9200

70

30

105

65

80

9280

10

30

105

65

0

9300

30

30

105

65

20

9400

130

70

105

65

20

9500

230

170

105

65

20

9600

330

270

105

65

20

Impact of Options Greeks before expiry:
Delta: The net Delta of a Long Iron Butterfly spread remains close
to zero if underlying assets remain at middle strike. Delta will move towards 1 if
underlying expires above higher strike price and Delta will move towards 1 if underlying
expires below the lower strike price.
Vega: Long Iron Butterfly has a positive Vega. Therefore, one
should buy Long Iron Butterfly spread when the volatility is low and expect to rise.
Theta: With the passage of time, if other factors remain same,
Theta will have a negative impact on the strategy.
Gamma: This strategy will have a long Gamma position, so the change
in underline assets will have a positive impact on the strategy.
How to manage Risk?
A Long Iron Butterfly is exposed to limited risk but risk involved is
higher than the net reward from the strategy, one can keep stop loss to further limit the
losses.
Analysis of Long Iron Butterfly strategy:
A Long Iron Butterfly spread is
best to use when you are confident that an underlying security will move significantly. Another way by
which this strategy can give profit is when there is an increase in implied
volatility. However, this strategy should be used by advanced traders as the risk to
reward ratio is high.