What Is the Iron Butterfly Options Strategy?

Options traders can trade calls and puts to potentially benefit from specific movements in stock prices. While you can buy or sell a single call or put to get started, other options trading strategies are more complex. The iron butterfly is an advanced options trading strategy that involves opening multiple options positions at the same time. The iron butterfly limits your losses but puts a cap on your gains. Understanding how this options trading strategy works can help grow your portfolio when a stock’s price doesn’t move too much.

What Is an Iron Butterfly?

An iron butterfly is an options trading strategy that revolves around two calls and two puts. Traders buy options within the same stock and expiration date, but not all of these contracts have the same strike prices. An iron butterfly has limits on how much you can gain and lose. You can initiate an iron butterfly on an options trading platform and know your max gain and max loss before getting started. 

How Does an Iron Butterfly Work?

Traders open iron butterfly positions by buying a call and put and selling a call and put. These trades take place simultaneously, but options traders choose strike prices based on how they believe the stock will move. The iron butterfly trader sells a call and put with the same strike price and collects two premiums. The trader then buys one call with a higher strike price and a put with a lower strike price than the sold contracts. 

An iron butterfly can look something like this: 

• Sell one call with a $50 strike price
• Sell one put with a $50 strike price
• Buy one call with a $55 strike price
• Buy one put with a $45 strike price

The long call and put limit a trader’s maximum losses. The difference between the premiums on the sold options and the costs to acquire the long options represents the max gain.

When to Use an Iron Butterfly

An iron butterfly is a useful options trading strategy if a trader believes a stock’s price will remain relatively flat over an extended duration. An iron butterfly trader benefits from time decay and low volatility. Iron butterflies are riskier during earnings season and the release of critical economic data because those events could lead to higher volatility. 

Iron Butterfly vs. Iron Condor

Iron butterflies and iron condors both involve buying a call and put and then selling a call and put. However, an iron condor setup has four different strike prices, while an iron butterfly has three different strike prices. An options trader using the iron condor has to select different strike prices for the sold call and sold put. The rest of the strategy is the same for iron butterflies and iron condors.

Example of Using an Iron Butterfly

Assume an options trader believes a stock priced at $100 per share will stay at that level for the next month. This trader can trade an iron butterfly with the following positions:

• Sell one call with a $100 strike price to realize a $3 premium
• Sell one put with a $100 strike price to realize a $2.50 premium
• Buy one call with a $115 strike price and pay a $1 premium
• Buy one put with an $80 strike price and pay a 50-cent premium

The trader in this example realizes a $5.50 premium from the sold positions and pays a $1.50 premium to enter the long call and put positions. The net gain from this iron butterfly is a $4 premium. If the stock’s price stays at $100 per share, the trader will realize the maximum gain. The losses can grow until the stock’s price falls below $80 per share or rises above $115 per share. The trader hopes the stock’s price will stay close to $100 per share. Far-out-of-the-money calls and puts increase the maximum profit from this trade but increase the potential downside if the stock’s price moves sharply in either direction. 

Possible Advantages and Limitations

The iron butterfly presents several advantages for options traders:

• Minimize your losses: The long call and put options limit your maximum loss. Some people only short options contracts without establishing any protection in case the underlying stock’s price moves differently than they anticipated.
• Receive a premium right away: You can use the proceeds from your iron butterfly and take much more risk to make other investments. Some people use the premium to buy more calls and puts, while others enter long positions in their favorite stocks.
• Profit when the market is sideways: Most traders do not position themselves to profit from slow markets. Iron butterflies let you make money even when the stock market is flat.

The iron butterfly has its risks, just like any trading strategy. Here are some things to keep in mind before using an iron butterfly.

• Limited upside: Your maximum gain for an iron butterfly is the difference between the premiums received from the sold options and the premiums paid for the long options. Some people prefer investments that have unlimited upside.
• More trades mean more commissions: Options traders pay commissions for each option's trade; you have to initiate four options positions, which means four commissions. If you exit the iron butterfly early, you will have four additional commissions.

Can the Iron Butterfly Help Your Portfolio?

Does it make sense to get involved with iron butterflies for your brokerage account? This strategy has limited upside but also minimizes your losses in case the stock price experiences significant volatility. An iron butterfly can be a useful addition to any options trading strategy for its immediate access to cash flow and customization based on your risk tolerance.

Frequently Asked Questions