What is an Iron Butterfly?
The Iron Butterfly strategy involves selling an at-the-money (ATM) call and put, while buying an out-of-the-money (OTM) call and put. It profits when the stock price remains near the ATM strike price.
- Sell a call and put option at the same strike price (e.g., $100).
- Buy a call option with a higher strike price (e.g., $110).
- Buy a put option with a lower strike price (e.g., $90).
- You receive a net credit for this strategy (premium from the sold options minus the premium of the bought options).
How Payoff Works:
If the stock price remains near the ATM strike price, you keep the net credit as profit. If the stock price moves far from the ATM strike price, your loss is limited to the difference between the strike prices minus the net credit received.
Example Payoff Scenarios:
- Stock Price = $85 (below the lower strike price $90): You make a $500 profit from the bought put at $90 but lose $1,500 from the sold put at $100. After adding the net credit of $500, the total payoff is - $500.
- Stock Price = $100 (at the middle strike price $100): All options expire worthless, and you keep the net credit of $500. The total payoff is $500.
- Stock Price = $115 (above the higher strike price $110): You make a $500 profit from the bought call at $110 but lose $1,500 from the sold call at $100. After adding the net credit of $500, the total payoff is - $500.