Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

For the past month, we have been discussing a strategy called an iron butterfly. This strategy benefits from the lack of movement of the underlying security. In order to show how this type of trade works, we chose a stock to enter a mock trade on. The stock we chose to follow was biotech company Amgen (AMGN). Though this stock had been in a mild uptrend, we felt resistance would hold and the stock would fall back into a range. So far, the stock has started to consolidate, but it has done so just above our max profit area. Below is a risk graph of our mock trade through February 4, 2003.

Notice how the stock has had a narrowing range this past week. This could be good or bad for our trade. Consolidation could result in a break out to either the up or downside. Obviously, if the stock rises too quickly, we would want to close the trade out for a minor loss. However, if the stock does decline, it can fall all the way to $45 and we still could achieve the maximum profit. Below is the week-to-week data for this trade:

Jan. 21, 2003
AMGN Iron Butterfly
Stock Price: $51.59
Buy 5 Feb 40 Puts @ 0.2 = -$100
Sell 5 Feb 45 Puts @ 0.55 = $275
Sell 5 Feb 50 Calls @ 2.60 = $1300
Buy 5 Feb 55 Calls @ 0.55 = -$275
Total Credit = $1200
Max Risk = $1300
Downside Breakeven = 42.60
Upside Breakeven = 52.40

Jan. 28, 2003
AMGN Iron Butterfly
Stock Price: $50.87
5 Feb 40 Puts @ 0.10 = $50
5 Feb 45 Puts @ 0.35 = -$175
5 Feb 50 Calls @ 2.75 = -$1375
5 Feb 55 Calls @ 0.50 = $250
Total Credit = $1,200
Cost to Close Trade = $1,250
Current Loss = $50 (not including commissions
Max Risk = $1300
Downside Breakeven = 42.60 (at expiration)
Upside Breakeven = 52.40 (at expiration)

Feb. 4, 2003
AMGN Iron Butterfly
Stock Price: $51.83
5 Feb 40 Puts @ 0.00 = $0
5 Feb 45 Puts @ 0.20 = -$100
5 Feb 50 Calls @ 2.65 = -$1325
5 Feb 55 Calls @ 0.35 = $175
Total Credit = $1,200
Cost to Close Trade = $1,250
Current Loss = $50 (not including commissions
Max Risk = $1300
Downside Breakeven = 42.60 (at expiration)
Upside Breakeven = 52.40 (at expiration)

Looking at the trade, we can see that the stock has raised nearly a dollar since we first entered the trade, yet we are still down just $50. Of course, this doesn’t include commissions, which can add up. However, it also shows we have quite a large leeway in this type of trade.

There are always questions about the exit strategy for a trade, so let’s go over some of the options for this iron butterfly. Before you enter any trade, you should know the possible risks and possible rewards. Some traders set their exit point based on the dollar amount lost or gained. Others use the underlying security in choosing their exit points. Your exit strategy is based on your risk tolerance and your reasons for entering the trade.

I tend to like using an exit strategy based on the reward and risk. For example, our max reward for this trade is $1,200. Thus, I might set an exit point at a percentage of the max reward. If I want a reward to risk ratio of 2-to-1, I would exit the trade if a loss of $600 was reached. Of course, any ratio could be used depending on your risk tolerance and success ratio. With a trade like an iron butterfly, we are likely to succeed at a higher rate than a straight call. Thus, we can take a slightly lower reward to risk ratio. If you don’t like the look of a trade when a stock reaches a certain point, you could also exit when this point is reached. For example, maybe you feel the benefits of this trade are lost once Amgen reaches a new six-month high. If so, you could exit once the stock reaches this point. Of course, you would want to have an exit point in case the stock plummets as well.

Another question I have gotten is how to physically close out this trade. Hopefully, Amgen will close between 45 and 50, making it so we have to do absolutely nothing. Remember, an iron butterfly is the combination of a bull put spread and a bear call spread. Thus, we only need to let these options expire worthless and keep the credit. If any of the options are in the money on expiration day, you could close them out. For example, if Amgen is at $52 on expiration Friday, you would just need to buy the sold 50 calls back. Even if you forget to close the option, you will be assigned by your broker. Then, you can go into the open market and buy the stock at $52 and sell it for the $50 that is required. If the stock rises above the purchased call or below the purchased put, you would use the purchased option to offset the sold option. Of course, this is where the max risk is reached.

Overall, this trade is still looking good, as the market seems poised for lower prices. We have two and a half weeks before expiration, so we’ll continue to track this trade until that time. If you have any questions or comments, please place them on my forum.


Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
Visit Jody's Forum

To search for other articles in this series, please click here.

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by Jody Osborne, Optionetics.com

• March 17, 2010
  Closing Wrap-Up, March 17
• March 17, 2010
  Morning Watch, March 17
• March 16, 2010
  Closing Wrap-Up, March 16
• March 16, 2010
  Real-World Trading: The Debit Spread, Part IV
• March 16, 2010
  Morning Watch, March 16