Iron Butterfly

Iron Butterfly (Iron Fly): Definition and Overview

An iron butterfly is a neutral options strategy that profits when the underlying asset’s price remains within a narrow range through option expiration and when implied volatility falls. It combines a short at-the-money straddle with out-of-the-money protective options (a long strangle), using four option legs with the same expiration:

• Sell one at-the-money call
• Sell one at-the-money put (same strike as the short call)
• Buy one out-of-the-money call (higher strike)
• Buy one out-of-the-money put (lower strike)

Because the position is opened for a net credit, it is a credit-spread strategy also known as an “iron fly.” It offers limited profit and defined risk.

How It Works

The iron butterfly is designed to capture premium when the underlying is expected to stay near a target price. Key mechanics:

• Maximum profit occurs if the underlying closes exactly at the center (short) strike at expiration; then the sold options expire worthless and you keep the net credit.
• Maximum loss is capped by the distance from the center strike to either long wing minus the initial credit received.
• Breakeven points at expiration are:
• Upper breakeven = center strike + net credit
• Lower breakeven = center strike − net credit
• The trade benefits from:
• Time decay (theta) as expiration approaches
• Declines in implied volatility (which reduce option premiums)

Setting Up an Iron Butterfly (Step‑by‑Step)

1. Choose a target price where you expect the underlying will be at or near expiration (the center strike).
2. Select options with the same expiration date near that forecasted day.
3. Sell one at-the-money call and one at-the-money put at the chosen center strike.
4. Buy one out-of-the-money call at a higher strike (the upper wing) and buy one out-of-the-money put at a lower strike (the lower wing). Ideally, the wings are equidistant from the center strike.
5. Ensure the wings are far enough apart to reflect your expected price range and to make commissions and risk/reward acceptable.

Example metrics to track before entering:
* Net credit received (maximum possible profit)
* Wing width (distance from center strike to wing strikes)
* Maximum possible loss = wing width − net credit
* Breakeven prices = center ± net credit

Practical Example (Summary)

A trader implements an iron butterfly on a stock with a center strike of $160 and collects a net credit of $5.50 per share. Breakeven prices are $160 ± $5.50 → $154.50 and $165.50. The position is profitable if the stock stays between those breakevens at expiration. If the stock finishes, for example, at $158 and the trader lets options expire, they could be assigned and end up buying stock at $160, but the initial credit reduces the net purchase cost.

Advantages

• Income potential: Collect premiums from the sold at-the-money options.
• Defined risk: Long wings cap losses in either direction.
• Relatively low capital outlay: Net credit setup can be more capital efficient than some alternatives.
• Flexibility: Positions can be adjusted (rolled) if market conditions change.
• Volatility play: Profits from falling implied volatility.

Limitations and Risks

• Limited reward: Maximum profit is the initial credit, which is capped.
• Commission and slippage: Four legs increase transaction costs; commissions can materially affect profitability.
• Assignment risk: Short options can be exercised, potentially resulting in stock ownership/obligation before expiration.
• Directional exposure: Large moves outside the wings cause losses up to the defined maximum.
• Requires accurate volatility and price-range forecast—best used in expected low- or declining-volatility environments.

How It Differs From Related Strategies

• Regular butterfly (all calls or all puts): Uses only calls or only puts to form the spread; an iron butterfly uses both calls and puts (an iron condor-like structure concentrated around a single center strike).
• Iron condor: Similar four‑leg structure but with the short strikes placed apart (creates wider profitable range and typically lower max profit).
• Naked put or calendar spreads: May accomplish some income objectives with fewer legs, but offer different risk profiles and volatility sensitivities. An iron butterfly provides explicit protection via the long wings that a naked put does not.

When to Use an Iron Butterfly

Consider using an iron butterfly when you expect:
* The underlying’s price to remain stable (range-bound) through expiration.
* Implied volatility to decrease (so option premiums fall).
* A trade with defined, limited risk and known profit potential.

Conclusion

The iron butterfly is a structured, income-oriented options trade that offers a predictable risk/reward profile when you forecast a narrow trading range and falling volatility. It requires careful selection of strikes and expirations, attention to commissions and assignment risk, and active management if the underlying moves outside the expected range.