Short
Iron Butterfly
Description
The
Short Iron Butterfly is another volatility strategy and is the opposite of a
Long Iron Butterfly, which is a rangebound strategy.
Short
iron butterflies are not particularly popular because they produce a net debit
and offer very small returns compared to straddles and strangles with only
slightly less risk.
The
Short Iron Butterfly involves putting together a Bear Put Spread and a Bull
Call Spread. The higher strike put shares the same strike as the lower strike
call to create the Short Butterfly shape. The resulting position is profitable
in the event of a big move by the stock. The problem is that the reward is
seriously capped and is typically dwarfed by the potential risk if the stock
fails to move.
Market
Opinion
Direction
neutral.
P/L
When
To Use
This
strategy is used when you anticipate your profits to occur from increased
volatility, and you want to do an inexpensive trade.
Example
XXXX
is trading at $52.87 on May 14, 2011.
Sell
August 2011 45 strike put for $1.88.
Buy
August 2011 50 strike put for $3.73.
Buy
August 2011 50 strike call for $7.03.
Sell
August 2011 55 strike call for $4.67.
Net
debit: premiums bought minus premiums sold = $4.21.
Benefit
The
benefit is that with a small capital outlay you can capture profit from a stock
that you believe is going to become more volatile, with your risk capped.
Risk
vs. Reward
The
risk is the net debit you pay. The reward is the difference between any
adjacent strike minus the net debit.
Net
Upside
Difference
between adjacent strikes minus net debit.
Net
Downside
Net
debit.
Break
Even Point
Break
even up: middle strike plus net debit.
Break
even down: middle strike minus net debit.
Effect
Of Volatility
Positive,
unless the stock moves outside of the outer strikes.
Effect
Of Time Decay
Negative,
because you have to wait for a big movement in the stock price.
Alternatives
Before Expiration
To
stem a loss, you can unravel the trade.
Alternatives
After Expiration
Unravel
the trade by selling the options you bought and buying back the options you
sold.