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Long Iron Butterfly
The long iron butterfly is also similar to the long butterfly and is used when the trader anticipates range-bound trading action. Rather than using all calls or all puts to create bullish and bearish vertical spreads, the iron butterfly uses one call vertical spread and one put vertical spread. In addition, this strategy results in a net credit to the account. It has both limited risk and limited reward.
The long iron butterfly is comprised of a bear call vertical spread and a bull put vertical spread with the same expiration month for a net credit. 1 OTM call is purchased and a near the money or ATM call is sold. At the same time, an OTM put is purchased and a near the money or ATM put sold. The maximum risk is the difference between the strike prices minus the net credit received when initiating the position. The long iron butterfly is profitable when the underlying remains between the upside breakeven and the downside breakeven. The maximum profit is limited to the net credit received when the position is first established. The upside breakeven for the long iron butterfly is the strike price of the short call plus the net credit. The downside breakeven is the strike price of the short put minus the net credit. Profits are maximized between the short option strike prices.
Once again, the Merrill Lynch Biotech HOLDRS fund (BBH) will be used for this range-bound position. Table 1-3, provides trade details for the position. BBH has been trading sideways for almost four months by late August and the trader believes it will remain in a narrow trading range. Its current price is 178.35 and the trader reviews Oct option premiums to evaluate a long iron butterfly position.
| Price of BBH = 178.35 |
Strike Prices
Oct 170 Put
Oct 175 Put
Oct 180 Call
Oct 185 Call
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Market Price
1.95
3.10
4.60
2.70
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Premium
+195
-310
-460
+270
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Table 1-3: BBH Option Premiums (8/2006)
The trade is established by purchasing 1 Oct 170 put, selling 1 Oct 175 put, selling 1 Oct 180 call and buying 1 Oct 185 call for a net credit of $305 ((1.95 – 3.10 – 4.60 + 2.70) x 100 = -305), which is the maximum profit for this trade. The maximum risk is the difference between the strike prices minus the net credit or $195 ((5 * 100) – 305 = 195). This will be realized if BBH makes a strong move to the upside or downside. The upside breakeven is 183.05 (180 + 3.05 = 183.05) and the downside breakeven is 171.95 (175 - 3.05 = 171.95).
| LONG IRON BUTTERFLY STRATEGY REVIEW |
Strategy = Combine a bear call spread and a bull put spread with the same expiration month
Market Opportunity = Look for a range-bound market that is expected to stay between the calculated breakeven points
Maximum Risk = Limited to the difference between the strikes minus the net credit
Maximum Profit = Limited to the net credit
Upside Breakeven = Lower strike price call (short call) plus the net credit
Upside Breakeven = Higher strike price put (short put) minus the net debit
Margin = Required. The amount is subject to your broker's discretion.
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| Strategies for Sideways Markets |
Market Scenario
Stock price initially range-bound to moderately bullish or bearish. Longer-term outlook bullish or bearish.
Stock price trades within a narrow range through expiration.
Stock price trades within a narrow range (but slightly less so than long butterfly) through expiration.
Stock price trades within a narrow range (but slightly less so than long butterfly) through expiration. |
Strategy
Calendar spread with short nearer term option used to off-set cost of longer-term, long option.
Long Butterfly which uses short, ATM options to serve as the body and long ITM and OTM options to serve as the wings.
Long Condor which uses short, ATM options to serve as the body and long ITM and OTM options to serve as the wings.
Long Iron Butterfly which uses short, ATM options to serve as the body and long ITM and OTM options to serve as the wings. |
Option Types
Calls or Puts
Calls or Puts
Calls or Puts
Calls & Puts |
Table 1-4: Strategies for Sideways Markets
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