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One of my favorite credit strategies to use in a sideways market is the Iron Butterfly. Properly implemented, you can capture a nice range of profitability while at the same time capping or minimizing your risk if a breakout occurs. The iron butterfly is similar to other butterfly spreads because it is a non-directional trade. The major difference is it is a credit trade rather than a debit trade. Also, it uses both calls and puts.

As options strategists the first step is to scan for markets and trades with the following characteristics:

1. Look for stagnation in the stock or index.
2. Particularly for a stock, make sure there are no major news items, which could cause a significant move in the stock during the time we are in the trade.
3. High Implied Volatility with a stabilizing price pattern. For a stabilizing price pattern we are looking for distinct support and resistance zones over the past 3 months. Many traders refer to this price action as channeling.
4. Verify the stock has options.
5. The shorter the time frame the better, since time decay accelerates during the final 30 days. Plus, the shorter the time frame, the higher the probability of profiting because there is less likelihood of a breakout in either direction. Just do not go out more than 45 days.

Once we have identified an excellent sideways candidate, we want to design the strategy. To construct the Iron Butterfly trade we will buy the lower strike out-of-the-money [OTM] put and the higher strike out-of-the-money [OTM] call. We will then sell both at-the-money [ATM] put and at-the-money [ATM] call.

To calculate the total credit you take the credit per unit and multiply it by the number of contracts we put on. Multiply the result by 100 since each contract represents 100 shares.

The maximum reward is equal to the total credit of the trade. To figure the maximum risk per unit you take the difference between the middle strike and either outside strike. Subtract the credit per unit from that result. We get the total maximum risk multiplying the risk per position by the number of contracts. Multiply that result by 100.

The breakevens on this trade are fairly straightforward to calculate. The lower break-even takes the middle strike and subtracts from it the credit per unit. The higher break-even takes the middle strike and adds to it the credit per unit. Finally, profit and losses are figured by taking the profit/loss per unit and multiply by the number of contracts. Multiply this result by 100.

An Iron Butterfly has an advantage over the traditional call or put butterfly, because we are selling both an at-the-money [ATM] put and at-the-money [ATM] call, which have the greatest time values. Given we are selling the options which are the richest in time value, we are putting ourselves in a position where time decay works for us not against us. Based on the fact time decay accelerates during the final 30 days of the options life, it is very important that this strategy be implemented for a shorter time frame.

To get a better feel how an Iron Butterfly is put together, look at the following example.

Assume the NASDAQ 100 (QQQ) is trading at 24. We will do an April 22 – 24 –26 Iron Butterfly. The trade is constructed as follows:

1.      Buy # of contracts April 22 Puts
2.      Buy # of contracts April 26 Calls
3.      Sell # of contracts April 24 Calls
4.      Sell # of contracts April 24 Puts    

This strategy has always been a favorite of mine primarily because of its relatively high reward-to-risk ratio, produces a credit, time decay is an advantage, it’s a short term trade, and even if the trade moves against us, we only have to close one side of the trade. For you beginning Optionetics students try paper trading this strategy for a couple of months. If it fits your trading style then think seriously about adding this strategy to your trading arsenal.

Happy Trading.


Jeff Neal
Staff Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
jeff@optionetics.com

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