In situations where the underlying stocks of a trading company are perceived to have a low volatility, strategies of limited trading for profits can be structured to spread the risks – that is what Iron Butterfly trading is all about.
To achieve a net credit to place on the trade, a trader needs to set up an account of Iron Butterfly that allows a trader to use the money invested in buying a lower strike option, and at the money put to sell a middle strike so that with the money call you can buy a higher strike.
When at expiration the underlying price of stick is equivalent to the prices at which the put and call options are sold, the Iron Butterfly strategy attains maximum profit.
The trader can enter the trade as profit by keeping the whole net credit received because at that price all the options expire without value.
Below is the formula for profit calculation:
- Net Premium Received-Commissions Paid = Maximum Profit
- When Price of Underlying = Strike Price of Short Call/Put, Maximum Profit Achieved
When the stock price is below the lower strike of the put bought, equal to or rises above the higher strike of the purchased call, the limited strategy of the iron butterfly might occur and lead to a maximum loss.
The difference in strike between the puts or (calls) minus the received net credit when the trade is entered is equal to the maximum loss in either situation.
Below is the formula for calculating maximum loss:
- Long Call Strike Price- Short Call Strike Price-Received Net Premium +Commission Paid = Max Loss
- When Price of Underlying<= Strike Price of Long Put Or Price of Underlying >= Long Call’s Strike Price then Max Loss Occurs.
The Iron Butterfly positions have two breakeven points which can be calculated using the following methods
- Strike Price of Short Call + Net Premium Received = Upper Breakeven Point
- Strike Price of Short Put – Net Premium Received = Lower Breakeven Point
If the stock of XYZ in June is trading at $40, and a trader of options executes an iron butterfly by purchasing a $50 for the Jul 30 Put, and writing a Jul 40 Put for 300 dollars, and another $300 for a Jul 40 call, and purchasing another $50 for a Jul 50 Call, when entering the trade the net credit received will be $500 which will be the possible maximum profit for the trader.
All the four options will be valueless when they expire, and the XYZ stocks will still be trading at $40 at expiration in July. The entire credit received as profit will be kept by the options trader which will also be his maximum profit.
All the options except the JUL 40 put sold expire without value if the XYZ stock is trading at $30 instead. The intrinsic value of the Jul 40 put will be $1000. TO exit the trade, the option has to be bought back.
When the credit received initially of $500 is subtracted, the options trader will suffer a maximum possible loss of $500.
On overall profit or loss, the charges for commissions can have a significant impact when the option spread strategies are implemented. Because of the four legs involved, their effect is more pronounced for the iron butterfly in this trade.