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hey what's going on everybody Chris here
from project option and in this options
trading strategies video I'm going to
teach you about the short iron butterfly
strategy so first we're going to talk
about the general characteristics of the
strategy then we're going to look at a
hypothetical example and we're going to
look at the expiration risk profile
graph so you can see what the strategies
performance looks like at expiration and
then lastly we're going to look at three
real short iron butterfly trade examples
so that you can see how the strategy
performs as the stock price is moving
through time so let's get right into it
alright so selling iron butterflies or a
short iron butterfly consists of
simultaneously selling a call input at
the same strike price essentially a
straddle while also purchasing and out
of the money call input which is a
strangle against the short option so
another way to conceptualize this trade
is by selling an a Simoni call spreads
and at the money put spread now
typically the width of both spreads will
be the same in which case you'll have
the same amount of risk on both sides so
we'll get to that in a minute so the
maximum profit potential of the trade is
the credit received times 100 so if you
sell a short iron butterfly for 10
dollars then your maximum profit is $10
times 100 or a thousand dollars per Iron
Butterfly now the maximum loss potential
is going to be the width of the widest
spread minus the credit received times
100 so as I said before you'll typically
have a short call spread and short put
spreads that are the same width but if
you do have if you do structure it in a
way where one of the short spreads has a
wider strike width then that side of the
trade will actually have more risk
now the breakeven prices are going to be
the short strike plus the credit
received and the short strike minus the
credit received so while you want that
stock price to stay right near your
short strike as time passes you actually
have a wider profitability range because
that credit you received gives you some
room to move now
the estimated probability of profit for
a short iron butterfly is typically
between 50 and 60% when you're when
you're selling wide spreads now if you
sell a very very narrow iron butterfly
then you really have a very narrow range
of profitability and your probability of
profit will be lower so that fifty and
sixty percent level is really for wide
or higher and butterflies now the
resulting position after expiration
depends on if one of your spreads is
entirely in the money or if only one of
the short options is in the money so if
either spread is entirely in the money
then no stock position is taken because
that short and long option will offset
now if only this short call is in the
money at expiration then you'll be
assigned negative 100 shares of stock
per short call now that means you'll be
short 100 shares of stock per short call
now has to be long if the short put is
in the money at expiration then you'll
be assigned plus 100 shares of stock per
short put now in regards to assignment
risk the short iron butterfly's strategy
does have a short call and a short put
component so if the short call is deep
in the money before expiration the
potential assignment risk is negative
100 shares per contract now if the short
put is in the money before expiration
the assignment risk is plus 100 shares
of stock per contract so if you know you
have a stock price that moves
significantly away from the short strike
then you do have to watch out for
assignment risk because if one of those
short options is deep in the money then
there's the potential that you might be
assigned early on that option alright so
now let's go ahead and construct a
hypothetical short iron butterfly trade
from the following option chain so at
the time of these option prices let's
say the stock price is currently at 300
dollars and we believe the stock price
will remain fairly close to 300 dollars
over the next X - X number of days now
to construct an Iron Butterfly we're
going to sell the 300 foot and the 300
call and then we're going to buy the 250
foot in the 350 call so we're
essentially buying we're selling the 300
straddle and we're buying the 250 350
strangle now if you want to
conceptualize the trade
as put spreads and call spreads then
we're selling the 300 250 put spread and
we're selling the 300 350 call spread
now for this trade we're going to
collect a net credit of twenty two
dollars and ninety four cents so with
that said let's go ahead and take a look
at the expiration risk profile graph for
this position all right so in this graph
we're looking at the potential profits
and losses at expiration based on
various stock prices so we can also see
our strikes that are used in the
strategy so we have the short put and
short call struck at $300 and then we
have a long put at $250 and the long
call at $350 so as we can see here our
maximum profit potential is two thousand
two hundred and ninety four dollars
which is the credit we received times
100 and we realize that if the stock
price is right at 300 at expiration now
obviously that's a very very low
probability scenario because there's
only one specific price that we can
realize maximum profit at so realizing
maximum profit on a short Iron Butterfly
strategy is very very rare however since
you collect such a large credit you can
still make a very very healthy profit if
the stock is anywhere near that $300
strike price so in this case we're
looking at a profitability range between
270 706 and 322 94 now those are our
breakeven prices which are solved for by
just subtracting the credit from the
short strike and also adding the credit
to the short strike so we have a nice
wide range of profitability there now if
we can see our maximum loss potential is
two thousand seven hundred and six
dollars and that occurs if the stock
price is below $250 or above $350 at
expiration
now that maximum loss comes from the
fact that we have $50 why put spreads
and $50 why call spreads and we
collected twenty two dollars and ninety
four cents for that so since the width
of the spreads is the same on both sides
we have the same risk on the upside and
downside so to solve for our maximum
loss potential we take the $50 wide
spread subtract the credit of 20 to 94
multiply that by 100 which gives us 2706
all right before getting into the real
trade examples let's go ahead and
quickly discuss the short iron
butterfly's and greek exposures as this
will help you understand how the
strategy performs before expiration so
in regards to Delta a short iron
butterfly typically begins with a delta
near zero because you're usually going
to sell and at the money straddle and
you're usually going to buy equidistant
wings from that short straddle so in
other words if you sell a 300 straddle
and you want to make a 25-point wide
iron Condor you would buy the 325 call
and the 275 put and in general this is
going to keep your deltas near zero now
you can structure a short iron butterfly
directionally by either opening up one
of those long options so let's say you
have a 25-point wide short call spread
and a hundred point wide short put
spread you obviously have more risk on
the downside and that'll give you a
slightly bullish bias now when you've
got in regards to gamma a short iron
butterfly position has negative gamma
now that means when the stock price
rises away from your short strike a
short iron butterfly position becomes
more short because it's position Delta
will be negative and on the other hand
when the stock price falls below the
short strike of the iron butterfly the
short iron butterfly position becomes
more long because it's Delta will be
more long more positive now an easy way
to conceptualize that is for maximum
profit to occur you want the stock price
to be right at your short strike at
expiration so if the stock price rises
above your short strike you want it to
come back down and that is represented
by your negative Delta and if the stock
price falls below your short strike you
want the stock to rise back up to your
short strike which is represented by the
positive Delta all right in regards to
theta a short iron butterfly position
has positive theta because we are net
short options and anytime your net short
options you want the option prices to
decrease because that'll lead to profits
for you because you can purchase those
options back at a lower price or they
expire worthless and then you
realize the maximum profit potential so
as time passes the extrinsic value of
options decays over time and that leads
to decreasing option prices which is of
course great for an Iron Butterfly
seller because we're net short options
so theta being positive means that time
is working for you in this position now
a short iron butterfly has negative Vega
and that's because since we're net short
options an increase in implied
volatility represents that option prices
are getting more expensive which
obviously leads to losses for a short
option position now on the other hand a
decrease in implied volatility indicates
that option prices are falling which is
obviously a great thing for a short Iron
Butterfly trader so when we put all
these Greeks together we learn that a
short iron butterfly position can make
money in two ways the first way is from
the passage of time since it has
positive theta and the second way is
from an ad crease in implied volatility
which is represented by the negative
Vega now there's two ways a short iron
butterfly can lose money and that's from
a large stock price movement in either
direction or an increase in implied
volatility so what you really want to
happen here as you want the stock price
to remain right near your short strike
and you want implied volatility to
decrease now on the other hand if the
stock price makes a move in either
direction you still could actually make
money because that positive theta could
offset those directional losses so all
of these things combined makes a short
iron butterfly a high probability trade
so let's go ahead and take a look at
some real examples so that you can see
how the strategy performs when the stock
price is changing
alright so example trade number one
we're going to look at an Iron Butterfly
that breaks even and that's when the
stock price is right near one of the
break-even prices at expiration so here
is the setup the initial stock price is
105 79 and to construct our Iron
Butterfly we're going to sell the 106
call input and then we're going to buy
the 97 foot and the 112 call now all of
these options expire in 45 days now to
enter this position we're going to
collect a net credit of 4 dollars and 42
cents which brings our breakeven prices
to 110 42 and 101 58 so that's the short
strike plus the credit and the short
strike minus the credit now our maximum
profit potential in this case is the
credit of 4 dollars and 42 cents times
100 which is 442 dollars now the maximum
loss potential is going to be a hundred
and fifty eight dollars on the upside
since we have a six dollar wide call
spread and we collected 4 dollars and 42
cents so 6 minus 4 42 times 100 is a
hundred and fifty eight dollars now on
the down side we have a nine dollar wide
foot sprint now remember I said that
whatever side has the wider spread has
more lost potential and this
demonstrates how that works so we have a
$9 wide foot spread and since we
collected a 4.42 cent credit that leaves
our max loss potential to the downside
at 458 dollars so with this particular
trade we have a slightly better slightly
bullish bias because we would rather see
the stock price increase then decrease
since we can lose more money when the
stock price decreases so let's go ahead
and take a look at what happens to this
position over time
all right so in the top part of the
graph here we're looking at these
changes in the stock price and then
we're looking at the stock price
relative to our short call input the
long foot the long call and our
breakevens for the Iron Butterfly so we
can see all of the these strategies
components alongside the stock price on
the bottom part of the graph we're
looking at the actual price of the Iron
Butterfly so when it decreases from our
entry price we'll have profits and when
it increases in value from our entry
price we'll have losses so in this
particular example we can see that the
stock price is in-between our breakeven
points for almost the entire period and
as we can see the short Iron Butterfly
actually did lose value over time and
that can be explained by the decrease in
extrinsic value as time passes so that's
that positive theta working for us now
unfortunately the stock price was right
near our upper breakeven of 1 1042 at
expiration which means that that short
1:06 call was worth about the same
amount that we collected for the entire
iron fly so since we collected 4 dollars
and 42 cents in this case and that short
call expired with the value of 4 dollars
and 42 cents that left this whole iron
fly position at a break-even point now
all of the other options expired
worthless but that short call was enough
to no offset any profits or losses so in
this case since the short 106 call was
in the money at expiration and that
whole entire cost rate was not in the
money then this position would actually
expire to negative 100 shares of stock
because a short call option expires to
negative 100 shares of stock
so if you did not want a short stock
position from this Iron Butterfly you
would have to buy back that short call
before expiration so this example just
goes to show that you know if the stock
price is near one of your breakeven
prices at expiration you're not going to
have any significant profits or losses
on the position because one of those
short options expired with the
equivalent value of your initial credit
alright so example trade number two
we're going to look at a maximum loss on
your butterfly now here's the setup
the initial stock price is seventy four
forty four and we're going to sell the
seventy five call and seventy five foot
and then we're going to buy the 70 foot
and the eighty call so in this example
we have a five dollar wide call spread
and a five dollar wide put spread which
means our maximum loss is going to be
the same on both sides
now for this iron butterfly we're going
to collect a credit of three dollars and
forty seven cents and that brings our
breakeven prices to seventy eight forty
seven on the upside and seventy one 53
on the down side now the maximum profit
potential is three dollars and forty
seven cents times 100 which comes out to
three hundred and forty seven dollars
now our maximum loss potential is the
five dollar spread width on both sides
minus 3.47 cents times 100 which comes
out to one hundred and fifty three
dollars so let's go ahead and see what
happens to this position over time all
right so as we can see here in the top
part of the graph we're looking at the
changes in the stock price relative
relative to our short iron butterfly
components and the break-even prices and
then the bottom part of the graph we're
looking at the actual value of that
short iron fly so as we can see here the
stock price started at seventy four
dollars and forty four cents and pretty
much just rallied the entire time we had
this trade on now ad expiration are
short seventy-five eighty call spread
was entirely in the money and therefore
that call spread expired to a value of
five dollars now since we sold this iron
fly for three dollars and forty seven
cents we realize our maximum loss
potential of one dollar and fifty three
cents per spread or a hundred and fifty
three dollars overall so this example
just shows that if you put on an iron
fly and the stock price makes a large
direct large movement in either
direction and one of your spreads is
entirely in the money at expiration then
you're going to realize your maximum
loss potential on the strategy so
unfortunately in this case the trade did
not work out but the good news is that
we have limited loss potential since we
are short a call spread and short a put
spread in the straight so at expiration
since the short
and long call are both in the money you
wouldn't actually have to close the
spread because those exercise and
assignments would offset so you wouldn't
have a stock position after expiration
but you shouldn't that you should be
aware of the fact that if you let
options expire in the money you will
incur exercise and assignment fees via
your brokerage firm so just be sure to
know your fees before you let an option
expire in the money the worst case
scenario is that you could just buy back
that short call spread you know ten or
fifteen minutes before they expire and
you'll avoid those exercise in this
assignment fees all right example trades
number three we're going to look at a
almost maximally profitable iron fly so
here is a set up the initial stock price
is seven hundred and fifty two dollars
and to construct our iron fly we're
going to sell the 750 foot and the 750
call and then we're going to buy the 625
foot in the 875 call all of these
options expire in 46 days now we're
going to collect a credit of sixty 6.15
cents which brings their breakeven
prices to eight sixteen fifteen on the
upside and 683 eighty-five on the
downside so our maximum profit potential
on this trade is going to be six
thousand six hundred and fifteen dollars
and our maximum loss potential is going
to be five thousand eight hundred and
eighty-five dollars so this is quite a
large position but let's go ahead and
see what happens alright so as we can
see here on the top part of the graph
we're looking at the stock price
relative to the short iron fly
components and then the bottom part of
the graph we're looking at the actual
price of that short iron fly so as we
can see here the stock price starts
right around $750 and immediately drops
to our breakeven price on the downside
of six 83-85 so obviously that's not
ideal but fortunately the stock price
did rally back a little bit and was
right below our shorts our short strike
at expiration and as we can see the iron
fly did decay steadily over time and as
we can see at expiration the spread was
worth about $10 now since we sold it for
around $66 so that would represent a
profit of $56 per
sly or around $5,600 / iron fly position
so this was a very very profitable trade
and that's because the stock price was
between our breakeven prices the entire
time and it expired right near our short
strike so this is pretty much the
best-case scenario for a short iron fly
position all right so let's go ahead and
recap the main concepts that we've
discussed in this video so first of all
selling iron butterflies is a
directionally neutral strategy that
consists of selling an at the money call
input spread with the same short strike
price so if you can either conceptualize
it as a short call spread and a short
put spread with the same short strike or
you can conceptualize it as a short
straddle and a long strangle now the
main profit drivers for short iron
butterflies are the passage of time
because the strategy has positive theta
and decreases in implied volatility
since the strategy has negative Vega now
to close a short iron butterfly before
expiration you can simply buy back the
short straddle and sell the long
strangle to lock in profits or losses
now though a short iron butterfly begins
directionally neutral the trade will
become directional if the stock price
trends in one direction so always
remember that you want the stock price
to be right at your short strike so if
it increases to a value higher than your
short strike you're going to be slightly
bearish because you'll have negative
deltas and if the stock price Falls to a
price below your short strike you're
going to be slightly bullish because you
want the stock price to increase back to
your short strike
thank you for watching this video
everybody I really hope you enjoyed it
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