Catching the Iron Butterfly – A Neutral Strategy for Range-Bound Markets - Ford Motor (NYSE:F), Walmart (NYSE:WMT)

Iron Butterfly Stock or options trading can offer the opportunity to profit in bullish or bearish markets. We discussed earlier this week in our weekly webinar how investors using options (long calls or long puts) can gain limited risk exposure to these market moves. Depending on their outlook, traders risk 100% of the options premium paid for unlimited profit potential should the stock move higher (calls) or lower with puts. This characteristic is one of the primary motivations for investors when they begin trading options.

But wait – there's more! Certain option strategies have the potential to profit in range-bound markets. So in a scenario where a stock trader might be totally neutral on a stock's outlook, – an options trader has the opportunity to profit even if the broad market (or a particular underlying stock) moves absolutely nowhere.

Not only a psychedelic 60s rock band, the iron butterfly is also an option-trading strategy investors may choose when trading a sideways-moving stock, ETF or index. Investors who sell iron butterflies typically don't expect the underlying security to be volatile between execution and expiration.

This strategy, which carries limited reward and limited risk, is constructed from a short straddle (one short at-the-money call and one short at-the-money put, both at the same strike) and a long strangle (one long out-of-the-money call and one long out-of-the-money put) surrounding the straddle. All options traded as part of an iron butterfly have the same expiration date.

You can also think of an iron butterfly as the combination of a credit bull put spread and a credit bear call spread, with the two spreads sharing the same short strike (unlike an iron condor, where the short strikes are separated). Whichever way is easier to conceptualize, it comes down to the same formula: two calls, two puts, four legs, and a net credit collected at the outset of the trade. While iron butterflies are similar to iron condors, they typically take in more premium at the outset because the credits for the strategy come from the at-the-money short straddle. This initial premium collected is the maximum potential reward on the trade. The maximum risk is the width of the spread less the initial premium received.

With complex strategies such as these, it is helpful to practice first with a virtual options account. Let's look at a purely hypothetical example of this strategy. (This should not be construed as a recommendation of any kind).

Let's say Albert has been watching Wal-Mart Stores WMT trade within a range and he doesn't expect it to stray far from the 55 level over the next several months. He executes the following trades for his iron butterfly:

Sells the March 55 call for $2.25
Sells the March 55 put for $2.25
Buys the March 50 put for $0.86
Buys the March 60 call for $0.49
Net credit of $3.15 per butterfly

Profit/Loss Graph:

The maximum profit occurs if WMT is trading right at the 55 strike when the options expire. At this point, all options expire worthless and the investor keeps 100% of the $3.15 credit collected.

The breakeven points are simply $51.85 and $58.15, or the short strike minus and plus the overall credit. Between these levels, the spread will be profitable at expiration. Maximum loss is capped at $1.85, or the difference between call (and put) strikes less the initial credit. This play has a potential return on risk of 170% in roughly 130 days. Maximum loss occurs below the 50 strike or above the 60 strike.

Profit and loss of Wal-Mart (WMT) iron butterfly

Iron butterflies can be modified depending on a trader's outlook and risk tolerance. For example, the wings can be wider to collect more upfront premium but this will also increase the max risk. For further elaboration on this strategy, tune in Tuesday (November 9) after the close for our Two Traders, One Strategy series. Trade Desk Manager Paul Oldani and I will walk through the specifics of this strategy – why and when investors trade iron butterflies, what some of the pros and cons are, and more. I hope you'll register today and join us on Tuesday.

The above information is provided by OptionsHouse, LLC (“OptionsHouse”) for informational and educational purposes only and is not intended as trading or investment advice or a recommendation that any particular security, transaction, or investment strategy is suitable for any specific person. You are solely responsible for your investment decisions. Commentary and opinions expressed are those of the author/speaker and not necessarily of OptionsHouse. Neither OptionsHouse nor any of its employees, officers, shareholders or affiliated companies guarantee the accuracy of or endorse the views or opinions of guest speakers or commentators. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature and are not guarantees of future results. Any examples used that discuss trading profits or losses may not take into account trading commissions or fees.

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