Long Iron Butterfly Options Strategy

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 strike-middle strike-net 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.