The Iron Butterfly option strategy gives a credit for entry, gains if the stock does not move, and has a known and limited maximum loss.

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Strategy: Butterfly

The Outlook: Neutral. Not expecting movement up or down before the expiration of the options. Entering when volatility is high is preferable.

The Trade: For the trade graphed above, an "Iron" Butterfly, sell puts and calls at the strike price nearest the stock price, buy calls one strike higher and buy puts one strike lower.

Gains when: Stock stays in a narrow range near the sold strike.

Maximum Gain: On an "Iron" Butterfly, limited to the initial credit.

Loses when: Stock moves beyond one of the breakeven points.

Maximum Loss : Limited to the largest difference in strike prices on one side times the number of shares represented, less the initial credit.

Breakeven Calculation: (For an "Iron" Butterfly) Lower breakeven = sold strike price - initial credit. Upper breakeven = sold strike price + initial credit.

Advantages compared to stock: Increased leverage, much less capital required, "built-in" stop loss, can gain from no stock movement or limited stock movement, can gain from a drop in implied volatility.

Disadvantages compared to stock: Will lose if stock rises or falls too much.

Volatility: after entry, increasing implied volatility is negative.

Time: after entry, the passage of time is positive.

Margin Requirement : Most options-oriented brokers will require the difference in the strike prices x the number of shares represented, reduced by the amount of credit taken in. In the example above the margin would be $187.

Variations: Use all calls or all puts. An "Iron" Butterfly is called Iron because it uses both puts and calls.

Comments

• A Butterfly trade is an "anti-gambler's trade". There is a good chance of a small profit, and a small chance of a loss. If you manage the trade so that you only take relatively small losses and not the maximum possible loss, you increase your chances of coming out ahead over the long term.

• A Butterfly trade can be thought of as a safer alternative to selling a Straddle. Just selling a Straddle could expose you to unlimited losses. The long options that are part of the Butterfly trade serve to limit losses to a manageable amount, even if the stock moves unexpectedly beyond one of the breakeven points.

• Butterfly trades require a large commission expense. Entering the trade will cost four commissions, and if you need to exit early there will be another four commissions. If you do not use the lowest-commission discount option brokers, the Butterfly trade might not make much sense. With most brokers, using more contracts will result in lower per-leg commissions overall and might make the trade reasonable.

• The Butterfly is an "anti-volatility" trade: it will benefit from a drop in volatility. For this reason it is a possible strategy to use at earnings time on a stock whose volatility has risen, but you do not expect the earnings report to really move the stock. After the earnings are out, the options may experience a "volatility crush", meaning they drop back to normal volatility, and the trade may benefit from that drop.

• If you have a neutral outlook, but want to benefit from an increase in volatility, the Calendar Call fits the bill. Plus, it requires only two commissions.

• The Butterfly strategy gets it's name from the graph. It reminded traders of a small creature with wings. Compare to the Condor graph, that looks like something bigger with wings.

Exits

• The Butterfly trade gains if the stock stays in a narrow range around the short strike and time passes. If the stock moves to one of the breakeven points at any time, the losses can multiply quickly up to the maximum possible. Using the graph at the top of the page, if the stock were to move to 46 or 54 at any time, it would be wise to cut the losses short at about $50, which is about a third of the maximum possible loss.

• If the reason for entry was to capture a decline in volatility, then an exit when the volatility drops makes sense.

• This trade is similar to the Calendar Call in that the closer you are to expiration, the greater your risk of giving back any gains you have. For this reason, it may be a good idea to exit Butterfly trades when there is a week left to expiration. See the Delta Neutral Trading page for more information.

The graphs below show that the Butterfly strategy can be set up with all Calls or all Puts, and the graph is nearly identical to the "Iron" Butterfly. The main difference is the Iron Butterfly is entered for a credit, and these trades have an initial debit.