Short Iron Butterfly Options Strategy

Nilesh Jain

17 Apr 2017

New Page 1

A Short Iron Butterfly strategy is implemented when an investor is expecting very little or no movement in the underlying assets. The motive behind initiating this strategy is to rightly predict the stock price till expiration and gain from time value. It is a limited risk and a limited reward strategy, similar to Long Call Butterfly strategy. A Short Iron Butterfly could also be considered as a combination of Bear Call Spread and Bull Put Spread.

When to initiate a Short Iron Butterfly?

A Short Iron Butterfly spread is best to use when you expect the underlying assets to trade in a narrow range as this strategy benefits from time decay factor. Also, when the implied volatility of the underlying assets increases unexpectedly and you expect volatility to come down, then you can apply Short Iron Butterfly strategy.

How to construct a Short Iron Butterfly?

A Short Iron Butterfly can be created by selling 1 ATM call, buying 1 OTM call, selling 1 ATM put and buying 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

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

Market Outlook

Neutral on market direction & Bearish on volatility

Motive

Earn from time value with limited risk

Upper Breakeven

Short Option (Middle) Strike price + Net Premium Received

Lower Breakeven

Short Option (Middle) Strike price - Net Premium Received

Risk

Limited

Reward

Limited to premium received

Margin required

Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs)

9200

Sell 1 ATM Call of strike price (Rs)

9200

Premium received (Rs)

70

Buy 1 OTM Call of strike price (Rs)

9300

Premium paid (Rs)

30

Sell 1 ATM Put of strike price (Rs)

9200

Premium received (Rs)

105

Buy 1 OTM Put of strike price (Rs)

9100

Premium paid (Rs)

65

Upper breakeven

9280

Lower breakeven

9120

Lot Size

75

Net Premium Received (Rs)

80

Suppose Nifty is trading at 9200. An investor, Mr. A thinks that Nifty will not rise or fall much by expiration, so he enters a Short Iron Butterfly by selling a 9200 call strike price at Rs 70, buying 9300 call for Rs 30 and simultaneously selling 9200 put for Rs 105, buying 9100 put for Rs 65. The net premium received to initiate this trade is Rs 80, which is also the maximum possible gain. This strategy is initiated with a neutral view on Nifty hence it will give the maximum profit only when the underlying assets expire at middle strike. The maximum profit from the above example would be Rs 6,000 (80*75). The maximum loss will also be limited to Rs 1,500 (20*75), if it breaks the upper and lower break-even points. Another way by which this strategy can give profit is when there is a decrease in implied volatility.

For the ease of understanding, we did not take into 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 Short Iron Butterfly spread remains close to zero if underlying assets remains at middle strike. Delta will move towards -1 if the underlying assets expire above the higher strike price and Delta will move towards 1 if the underlying assets expire below the lower strike price.

Vega: Short Iron Butterfly has a negative Vega. Therefore, one should initiate Short Iron Butterfly spread when the volatility is high and is expected to fall.

Theta: With the passage of time, if other factors remain the same, Theta will have a positive impact on the strategy.

Gamma: This strategy will have a short Gamma position, so the change in underline asset will have a negative impact on the strategy.

How to manage Risk?

A Short Iron Butterfly is exposed to limited risk compared to reward, so carrying overnight position is advisable.

Analysis of Short Iron Butterfly strategy:

A Short Iron Butterfly spread is best to use when you are confident that an underlying security will not move significantly and will stay in a range. Downside risk is limited to the net premium received, and upside reward is also limited but higher than the risk involved. It provides a good reward to risk ratio.

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Whether to invest in equities or mutual funds is a question that has plagued every investor. As someone who needs the best value for his/her investment should you invest in equity directly or via mutual funds?

Let’s start by first understanding what these two terms ‘equities’ and ‘mutual funds’ stand for-

Equities- Equities generally represent ownership of a company. If you own any equity in a company, you are a part owner of the said company (depending on how much equity you own).

Mutual Funds – It is an investment scheme which is professionally managed by an asset management company. It pools together the resources of a group of people and invests their money in equities, debentures, bonds and other securities.

Why choose mutual funds over equities?

For people who’ve never invested in either stocks or mutual funds, it is hard to know which is better and where to start. Broadly speaking, if you are a novice investor, mutual funds are not only less risky but also way easier to manage. Here are some ways in which investing in mutual funds is beneficial as opposed to investing in equities -

Diversification

Mutual funds provide more diversification as compared to an individual equity stock. When you invest in equity, you are investing in a single company which has its inherent risk. For example, if you invest Rs.20,000 in buying equities of one company, you could face a total loss if that particular company performs poorly in the market.  

If you invest the same amount in mutual funds, it will be invested in different kinds of stocks and financial instruments, high-risk and low-risk both, so you might not face total loss even if one company does poorly.

Scale of Investment and Lower Costs

For an individual investor buying and selling stocks is a difficult task due to its high price. Thus, any gains made from stock appreciation are nullified if the overall trading costs are considered. Comparatively with mutual funds, as the money is pooled from a large number of investors, the cost per individual is lowered.  

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Short Iron Butterfly Options Strategy

Nilesh Jain

17 Apr 2017

New Page 1

A Short Iron Butterfly strategy is implemented when an investor is expecting very little or no movement in the underlying assets. The motive behind initiating this strategy is to rightly predict the stock price till expiration and gain from time value. It is a limited risk and a limited reward strategy, similar to Long Call Butterfly strategy. A Short Iron Butterfly could also be considered as a combination of Bear Call Spread and Bull Put Spread.

When to initiate a Short Iron Butterfly?

A Short Iron Butterfly spread is best to use when you expect the underlying assets to trade in a narrow range as this strategy benefits from time decay factor. Also, when the implied volatility of the underlying assets increases unexpectedly and you expect volatility to come down, then you can apply Short Iron Butterfly strategy.

How to construct a Short Iron Butterfly?

A Short Iron Butterfly can be created by selling 1 ATM call, buying 1 OTM call, selling 1 ATM put and buying 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

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

Market Outlook

Neutral on market direction & Bearish on volatility

Motive

Earn from time value with limited risk

Upper Breakeven

Short Option (Middle) Strike price + Net Premium Received

Lower Breakeven

Short Option (Middle) Strike price - Net Premium Received

Risk

Limited

Reward

Limited to premium received

Margin required

Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs)

9200

Sell 1 ATM Call of strike price (Rs)

9200

Premium received (Rs)

70

Buy 1 OTM Call of strike price (Rs)

9300

Premium paid (Rs)

30

Sell 1 ATM Put of strike price (Rs)

9200

Premium received (Rs)

105

Buy 1 OTM Put of strike price (Rs)

9100

Premium paid (Rs)

65

Upper breakeven

9280

Lower breakeven

9120

Lot Size

75

Net Premium Received (Rs)

80

Suppose Nifty is trading at 9200. An investor, Mr. A thinks that Nifty will not rise or fall much by expiration, so he enters a Short Iron Butterfly by selling a 9200 call strike price at Rs 70, buying 9300 call for Rs 30 and simultaneously selling 9200 put for Rs 105, buying 9100 put for Rs 65. The net premium received to initiate this trade is Rs 80, which is also the maximum possible gain. This strategy is initiated with a neutral view on Nifty hence it will give the maximum profit only when the underlying assets expire at middle strike. The maximum profit from the above example would be Rs 6,000 (80*75). The maximum loss will also be limited to Rs 1,500 (20*75), if it breaks the upper and lower break-even points. Another way by which this strategy can give profit is when there is a decrease in implied volatility.

For the ease of understanding, we did not take into 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 Short Iron Butterfly spread remains close to zero if underlying assets remains at middle strike. Delta will move towards -1 if the underlying assets expire above the higher strike price and Delta will move towards 1 if the underlying assets expire below the lower strike price.

Vega: Short Iron Butterfly has a negative Vega. Therefore, one should initiate Short Iron Butterfly spread when the volatility is high and is expected to fall.

Theta: With the passage of time, if other factors remain the same, Theta will have a positive impact on the strategy.

Gamma: This strategy will have a short Gamma position, so the change in underline asset will have a negative impact on the strategy.

How to manage Risk?

A Short Iron Butterfly is exposed to limited risk compared to reward, so carrying overnight position is advisable.

Analysis of Short Iron Butterfly strategy:

A Short Iron Butterfly spread is best to use when you are confident that an underlying security will not move significantly and will stay in a range. Downside risk is limited to the net premium received, and upside reward is also limited but higher than the risk involved. It provides a good reward to risk ratio.

Have Referral Code?