TOOLS OF THE TRADE

THE IRON BUTTERFLY

The Iron Butterfly is much the same as the Iron Condor discussed in last week’s blog.  It is comprised of both puts and calls and has four legs to the trade.  The difference is that the Iron Butterfly places the short call and short put at the same strike price.  As a result, we have a nonexistent body as opposed to the body of the Condor, which is quite wide. 

The strategy optimizes an absolutely stagnant trend.  Maximum reward is achieved when the underlying stock or index finishes precisely at the strike price of the short options.  The position quickly begins to lose as the underlying moves in either direction away from the short put and call strike.

The Iron Butterfly is a credit spread and the maximum reward is the credit received.  The credit equals the short options credit less the debit of the long options.  Maximum risk is the difference in the strike price of the short and long option less the total credit received from both short options. 

I will normally only place this trade with a very short period to expiration, given the trade will lose if it has time to move from the midpoint of the Iron Butterfly.  Study the risk graph and you should gain an understanding of the trade’s potential and its’ risk and reward.  Best, Robin

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