Iron Butterfly - Know Your Options

No this is not an article on the rock bank by the same name (they sang ‘In-A-Gadda-Da-Vida’).

Instead, this is an options strategy that's seldom talked about, but is a great strategy to know.

It's considered a neutral strategy, and you would employ this method if you believe a stock will trade within a certain range by its option's expiration.

How it Works

The trade consists of writing an at-the-money call and an at-the-money put; then buying an out-of-the-money call and an out-of-the-money put.

Since I just put this trade on for myself recently (in Apple (AAPL)), let's use my fills as an illustration.

First, here are all the parts. Then we'll dissect it:

- Sold to open 1 Sept 2010 260 Call at 12.71 (collected $1,271)
- Bought to open 1 Sept 2010 270 Call at 8.35 (paid $835)

- Sold to open 1 Sept 2010 260 Put at 13.65 (collected $1,365)
- Bought to open 1 Sept 2010 250 Put at 9.25 (paid $925)

We collected $436 on the call side. And we collected $440 on the put side. That's a total credit of $876 to put the trade on.

Essentially what we did was put on two spreads: one bear call spread and one bull put spread. Another way of looking at this is that we put on a short straddle (the short 260 call and put) and a long strangle (the long 270 and 250 call and put).

Regardless of how one looks at it, it's called an Iron Butterfly.

How to Make Money

The maximum profit on this trade is the total credit that was collected, which in this case is $876.

The maximum loss is the size of the spread in either direction (which in this case is 10.00), less the credit received (8.76), for a maximum loss of 1.24 or $124. (That's right, the maximum loss is only -$124 sans commissions and fees.)

The reward to risk ratio is pretty favorable if you can collect enough premium. In this case we're risking $124 for a maximum gain of $876. (Too good to pass up.)

Our maximum profit however will only be seen if Apple closes at $260.00 at expiration (which in this case is Sept. 17, 2010).

At $260, all the options will expire worthless, which means I'll keep the entire credit of $876.

As Apple moves away from $260 in either direction, the profit potential gets smaller.

However, only if Apple closes above $270 or below $250 at expiration could I lose the maximum amount possible (in this case $129.)

Why? Let's look at it. If at expiration, Apple closes at $280 for example:

- the $260 call I wrote would be worth $2,000, less the $1,271 I collected, for a loss of -$729
- the 270 call I bought would be worth $1,000, less the $835 I paid, for a gain of $165
- but both puts would expire worthless, which means I'll keep the entire $440 on those

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- that gives me a net loss of -$124

Even if Apple went to $300 or higher, my maximum loss is still only -$124. Same thing if Apple dropped to $250 or even $200 or lower. The max loss is still always only -$124.

Additional Considerations

It's highly unlikely that the underlying stock will expire exactly at your price. But within a few dollars on either side, you're still talking about roughly $600 to $700 profit. Pretty cool.

Also, as the trade gets closer to expiration and you see that you're trade is more than 90% of its maximum profit potential, consider exiting the trade. Why? Because you're then risking the lion's share of what it has made so far (over $788 in this case) to pick up an extra $87. So you might want to take the money and run. Because a spike up or down, even on the very last day, could take you out of that profit range and turn it into a loss. No harm in locking that profit in.

Either way, this is a great strategy to use. It is quite easy to put on. And you can get pretty creative with options -- potentially profiting in any direction or no direction at all.

Next time we'll uncover another little-known strategy, but with a big payoff.

You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.

And be sure to check out our new Zacks Options Trader.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

 
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