Short Iron Butterfly

 

Description

         

The Short Iron Butterfly is another volatility strategy and is the opposite of a Long Iron Butterfly, which is a rangebound strategy.

 

Short iron butterflies are not particularly popular because they produce a net debit and offer very small returns compared to straddles and strangles with only slightly less risk.

            

The Short Iron Butterfly involves putting together a Bear Put Spread and a Bull Call Spread. The higher strike put shares the same strike as the lower strike call to create the Short Butterfly shape. The resulting position is profitable in the event of a big move by the stock. The problem is that the reward is seriously capped and is typically dwarfed by the potential risk if the stock fails to move.        

 

Market Opinion

 

Direction neutral.

 

P/L

 

 

 

 

 

 

When To Use

 

This strategy is used when you anticipate your profits to occur from increased volatility, and you want to do an inexpensive trade.

 

Example

 

XXXX is trading at $52.87 on May 14, 2011.

Sell August 2011 45 strike put for $1.88.

Buy August 2011 50 strike put for $3.73.

Buy August 2011 50 strike call for $7.03.

Sell August 2011 55 strike call for $4.67.

 

Net debit: premiums bought minus premiums sold = $4.21.

 

Benefit

 

The benefit is that with a small capital outlay you can capture profit from a stock that you believe is going to become more volatile, with your risk capped.

 

Risk vs. Reward

 

The risk is the net debit you pay. The reward is the difference between any adjacent strike minus the net debit.

 

Net Upside

 

Difference between adjacent strikes minus net debit.

 

Net Downside

 

Net debit.

 

Break Even Point

 

Break even up: middle strike plus net debit.

 

Break even down: middle strike minus net debit.

 

Effect Of Volatility

 

Positive, unless the stock moves outside of the outer strikes.

 

Effect Of Time Decay

 

Negative, because you have to wait for a big movement in the stock price.

 

Alternatives Before Expiration

 

To stem a loss, you can unravel the trade.

 

Alternatives After Expiration

 

Unravel the trade by selling the options you bought and buying back the options you sold.