Reverse Iron Butterfly Explained

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Good Choice for Beginners!
    Free Trading Education, Free Demo Account!
    Get a Sign-Up Bonus Now!

  • Binomo
    Binomo

    2nd in our ranking!

Reverse Iron Butterfly

The reverse (short) iron butterfly is a limited risk, limited profit options trading strategy that is designed to make a profit when the underlying stock price makes a sharp move either up or down.

Reverse Iron Butterfly Construction
Sell 1 OTM Put
Buy 1 ATM Put
Buy 1 ATM Call
Sell 1 OTM Call

To setup a reverse iron butterfly, the options trader sells a lower strike out-of-the-money put, buys a middle strike at-the-money put, buys another middle strike at-the-money call and sells another higher strike out-of-the-money call. There will be a net debit taken to put on the trade.

Limited Profit Potential

Maximum gain for the reverse iron butterfly is limited and is achieved when the underlying stock price drops to be at or below the strike price of the short put option or rise to be above or equal to the strike price of the short call option. In either situation, maximum profit is equal to the difference in strike between the calls (or puts) minus the net debit taken when entering the trade.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Short Call (or Long Put) – Strike Price of Long Call (or Short Put) – Net Premium Paid – Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Short Call

Limited Risk

Maximum loss for the reverse iron butterfly is also limited and occurs when the underlying stock price at expiration is equal to the strike price of the long call and the long put options. At this price, all the options expire worthless and the options trader suffers a loss equal to the initial debit taken to enter the trade.

The formula for calculating maximum loss is given below:

  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying = Strike Price of Long Call/Put

Breakeven Point(s)

There are 2 break-even points for the reverse iron butterfly position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
  • Lower Breakeven Point = Strike Price of Long Put – Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader executes a reverse iron butterfly by selling a JUL 30 put for $50, buying a JUL 40 put for $300, buying another JUL 40 call for $300 and selling another JUL 50 call for $50. The net debit taken to enter this trade is $500, which is also his maximum possible loss.

On options expiration in July, XYZ stock is still trading at $40. All the 4 options expire worthless and the options trader suffers a loss equal to the intial debit taken of $500.

If XYZ stock is instead trading at $30 on expiration, all the options except the long JUL 40 put option expire worthless. The JUL 40 put will have an intrinsic value of $1000. Selling this put option will net the options trader $1000 and subtracting the initial $500 debit taken to enter this trade, the trader is left with $500 in profits. This is also his maximum possible profit. This maximum profit situation also occurs if the stock price had gone up to $50 or beyond instead.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Good Choice for Beginners!
    Free Trading Education, Free Demo Account!
    Get a Sign-Up Bonus Now!

  • Binomo
    Binomo

    2nd in our ranking!

To further see why $500 is the maximum possible profit, lets examine what happens when the stock price falls below $30 to $25 on expiration. At this price, only the short JUL 30 put and the long JUL 40 put options expire in-the-money. The short JUL 30 put has an intrinsic value of $500 while the long JUL 40 put is worth $1500. Selling the long put for $1500 to buy back the short put at $500, and factoring in the intial debit of $500 taken upon entering the trade, he is again left with $500 in profits.

Note: While we have covered the use of this strategy with reference to stock options, the reverse iron butterfly is equally applicable using ETF options, index options as well as options on futures.

Commissions

Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the reverse iron butterfly as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.

If you make multi-legged options trades frequently, you should check out the brokerage firm OptionsHouse.com where they charge a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the reverse iron butterfly in that they are also high volatility strategies that have limited profit potential and limited risk.

Reverse Iron Butterfly Spread

The reverse iron butterfly spread is classified as a volatile options trading strategy, which means it’s designed to be used when your expectation is that a security will move significantly in price but you aren’t clear in which direction. It’s one of the most advanced strategies in this category, with four transactions required involving both calls and puts.

Potential profits and potential losses are limited, so you can have a clear idea of what you stand to make, or lose, at the time if applying the strategy. Full details on the reverse iron butterfly spread can be found below.

Key Points

  • Volatile Strategy
  • Not Suitable for Beginners
  • Four Transactions (buy calls/write calls/buy puts/write puts)
  • Debit Spread (upfront cost)
  • Medium Trading Level Required

When to Employ the Reverse Iron Butterfly Spread

The reverse iron butterfly spread is designed to be used when you believe that a security is going to move significantly in price, but you are unsure as to which direction it will move in. This strategy will return a profit regardless of which way the price of the security moves, as long the move is big enough.

This is actually one of the least efficient volatile options trading strategies; the potential profits return on investment is lower, and the maximum loss is higher, than both the short butterfly and the short condor. However, those strategies are credit spreads and not every trader has an account that will allow for these.

The reverse iron butterfly spread is a debit spread and is a viable strategy if you are unable to create credit spreads.

How to Create a Reverse Iron Butterfly Spread

There are four legs in the reverse iron butterfly spread, meaning you must place a total of four orders to create it. These orders can be placed simultaneously for simplicity, or if you prefer you can use legging techniques to try and maximize profitability. You have to buy and write both call and put options. The four transactions required are as follows.

  • Writing out the money calls
  • Buying at the money calls
  • Writing out of the money puts
  • Buying at the money puts

Each leg should contain the same amount of options, and you should use contracts that share the same expiration date. The two short legs, where you write out of the money options, should use strike prices that are the same distance from the current trading price of the underlying security, but it’s down to you to decide exactly how far out of the money you want these options to be.

It’s worth bearing in mind that the closer the strikes are to the current trading price of the underlying security the higher their price will be, and you’ll receive more for writing them and thus reduce the size of the net debit. However, you’ll also be reducing the potential profits too.

Below is an example of how you can apply the reverse iron butterfly spread. To keep the example as simple as possible we have used rounded options prices rather than precise market data. We have also ignored commission costs.

  • Company X stock is trading at $50, and you are forecasting a sizable move in either direction.
  • You write 1 contract (100 options, $1.50 per option) of out of the money calls (strike $52) for a credit of $150. This is Leg A.
  • You buy 1 contract (100 options, $2 per option) of at the money calls (strike $50) at a cost of $200. This is Leg B.
  • You write 1 contract (100 options, $1.50 per option) of out of the money puts (strike $48) for a credit of $150. This is Leg C.
  • You buy 1 contract (100 options, $2 per option) of at the money puts (strike price $50) at a cost of $200. This is Leg D.
  • The total spent on options is $400 while the total credit received is $300. You have created a reverse iron butterfly spread for a total net debit of $100.

Potential for Profit & Loss

The reverse iron butterfly spread needs the price of the underlying security to move a certain amount in either direction in order to make a profit, and the strategy will result in a loss if the price doesn’t move enough.

One of the advantages of this strategy is that you can calculate the exact break-even points at the time of establishing the spread. You then know how much you need the price of the underlying security to move by if you are going to make a profit. You can also calculate the maximum profit you can make and the maximum amount you can lose.

We have provided the relevant calculations below, along with some hypothetical scenarios and what the results would be.

  • If the price of Company X stock stayed exactly at $50 by the time of expiration, the options written in Legs A and C would expire worthless, as would the ones bought in Legs B and D. With no further returns and no further liabilities, you would lose your initial investment of $100.
  • If the price of Company X stock went up to $52 by the expiration date, the calls written in Leg A would be at the money and therefore would expire worthless. The ones bought in Leg B would be worth around $2 each, for a total value of $200. The puts in Legs C and D would be worthless. With $200 worth of options, and taking into account your initial investment of $100, you would make $100 profit.
  • If the price of Company X stock went down to $47 by the expiration date, the calls in Legs A and B would be out of the money and worthless. The puts written in Leg C would be worth around $1 each, for a liability of $100. The puts bought in Leg D would be worth around $3 each, for a total value of $300. With $300 worth of options and a liability of $100, and taking into account your initial $100 investment, you would make a total profit of $100.
  • Maximum profit is made when “Price of Underlying Stock = or > Strike of Leg A” or “Price of Underlying Stock = or Lower Break-Even Point”
  • The maximum loss will be made if “Price of Underlying Security = Strike of Legs B/D”
  • Maximum loss is limited to “Total Net Debit”

Summary

The reverse iron butterfly is a complex strategy, and not just because of the four transactions involved. The commission charges can also be quite high due to the number of transactions. The short butterfly and the short condor are probably preferable, if your broker allows you to create credit spreads. If you can only create debit spreads, then the reverse iron butterfly is a perfectly acceptable alternative.

Butterfly Spread

What Is a Butterfly Spread?

A butterfly spread is an options strategy combining bull and bear spreads, with a fixed risk and capped profit. These spreads, involving either four calls or four puts are intended as a market-neutral strategy and pay off the most if the underlying does not move prior to option expiration.

Key Takeaways

  • There are multiple butterfly spreads, all using four options.
  • All butterfly spreads use three different strike prices.
  • The upper and lower strike prices are equal distance from the middle, or at-the-money, strike price.
  • Each type of butterfly has a maximum profit and a maximum loss.

Understanding Butterflies

Butterfly spreads use four option contracts with the same expiration but three different strike prices. A higher strike price, an at-the-money strike price, and a lower strike price. The options with the higher and lower strike prices are the same distance from the at-the-money options. If the at-the-money options have a strike price of $60, the upper and lower options should have strike prices equal dollar amounts above and below $60. At $55 and $65, for example, as these strikes are both $5 away from $60.

Puts or calls can be used for a butterfly spread. Combining the options in various ways will create different types of butterfly spreads, each designed to either profit from volatility or low volatility.

Long Call Butterfly

The long butterfly call spread is created by buying one in-the-money call option with a low strike price, writing two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. Net debt is created when entering the trade.

The maximum profit is achieved if the price of the underlying at expiration is the same as the written calls. The max profit is equal to the strike of the written option, less the strike of the lower call, premiums, and commissions paid. The maximum loss is the initial cost of the premiums paid, plus commissions.

Short Call Butterfly

The short butterfly spread is created by selling one in-the-money call option with a lower strike price, buying two at-the-money call options, and selling an out-of-the-money call option at a higher strike price. A net credit is created when entering the position. This position maximizes its profit if the price of the underlying is above or the upper strike or below the lower strike at expiry.

The maximum profit is equal to the initial premium received, less the price of commissions. The maximum loss is the strike price of the bought call minus the lower strike price, less the premiums received.

Long Put Butterfly

The long put butterfly spread is created by buying one put with a lower strike price, selling two at-the-money puts, and buying a put with a higher strike price. Net debt is created when entering the position. Like the long call butterfly, this position has a maximum profit when the underlying stays at the strike price of the middle options.

The maximum profit is equal to the higher strike price minus the strike of the sold put, less the premium paid. The maximum loss of the trade is limited to the initial premiums and commissions paid.

Short Put Butterfly

The short put butterfly spread is created by writing one out-of-the-money put option with a low strike price, buying two at-the-money puts, and writing an in-the-money put option at a higher strike price. This strategy realizes its maximum profit if the price of the underlying is above the upper strike or below the lower strike price at expiration.

The maximum profit for the strategy is the premiums received. The maximum loss is the higher strike price minus the strike of the bought put, less the premiums received.

Iron Butterfly

The iron butterfly spread is created by buying an out-of-the-money put option with a lower strike price, writing an at-the-money put option, writing an at-the-money call option, and buying an out-of-the-money call option with a higher strike price. The result is a trade with a net credit that’s best suited for lower volatility scenarios. The maximum profit occurs if the underlying stays at the middle strike price.

The maximum profit is the premiums received. The maximum loss is the strike price of the bought call minus the strike price of the written call, less the premiums received.

Reverse Iron Butterfly

The reverse iron butterfly spread is created by writing an out-of-the-money put at a lower strike price, buying an at-the-money put, buying an at-the-money call, and writing an out-of-the-money call at a higher strike price. This creates a net debit trade that’s best suited for high-volatility scenarios. Maximum profit occurs when the price of the underlying moves above or below the upper or lower strike prices.

The strategy’s risk is limited to the premium paid to attain the position. The maximum profit is the strike price of the written call minus the strike of the bought call, less the premiums paid.

Example of a Long Call Butterfly

An investor believes that Verizon stock, currently trading at $60 will not move significantly over the next several months. They choose to implement a long call butterfly spread to potentially profit if the price stays where it is.

An investor writes two call options on Verizon at a strike price of $60, and also buys two additional calls at $55 and $65.

In this scenario, an investor would make the maximum profit if Verizon stock is priced at $60 at expiration. If Verizon is below $55 at expiration, or above $65, the investor would realize their maximum loss, which would be the cost of buying the two wing call options (the higher and lower strike) reduced by the proceeds of selling the two middle strike options.

If the underlying asset is priced between $55 and $65, a loss or profit may occur. The amount of premium paid to enter the position is key. Assume that it costs $2.50 to enter the position. Based on that, if Verizon is priced anywhere below $60 minus $2.50, the position would experience a loss. The same holds true if the underlying asset were priced at $60 plus $2.50 at expiration. In this scenario, the position would profit if the underlying asset is priced anywhere between $57.50 and $62.50 at expiration.

This scenario does not include the cost of commissions, which can add up when trading multiple options.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Good Choice for Beginners!
    Free Trading Education, Free Demo Account!
    Get a Sign-Up Bonus Now!

  • Binomo
    Binomo

    2nd in our ranking!

Like this post? Please share to your friends:
How To Start Binary Options Trading 2020
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: