What is an Iron Butterfly Strategy?

Last Updated: 13 Jan 2025

What is an Iron Butterfly Strategy? – Meaning & Example

An Iron Butterfly Strategy or Iron Fly Strategy is an options trading strategy that combines multiple calls and put options to devise a market-neutral strategy. Iron Fly Option Strategy involves running a short call spread and a short put spread simultaneously. The spread converges at a middle strike price.

Example of Iron Butterfly Strategy

Consider the following example: the spot price for Tata Motors in September is Rs. 378.50. To deploy the iron butterfly options strategy, the trader will execute the following trades expiring in October –

Buy a Put Option A with a strike price of Rs. 360 at a premium of Rs. 1.25

Buy a Call Option B with a strike price of Rs. 400 at a premium of Rs. 1.10

Sell a Call Option C with a strike price of Rs. 380 at a premium of Rs. 5.65

Sell a Put Option D with a strike price of Rs. 380 at a premium of Rs. 7.50

Now, the trader’s profit at an entry-level is Rs. 10.80 i.e., the difference between the premium paid and received. To deconstruct the strategy, let’s evaluate the below-mentioned scenarios –

• Case 1 – Tata Motors closes at Rs. 380 in October

In this case, options A and B will be out-of-the-money and expire worthless. Options C and D will be at the money and expire worthless. Therefore, the overall gain will be a net premium earned of Rs. 10.80.

• Case 2 –  Tata Motors closes at Rs. 390 in October

Options A, B, and D will be out-of-the-money and expire worthless. On squaring off Option C, a loss will be incurred to the tune of Rs. 10, the difference between spot and strike price. Hence, the net gain will be limited to Rs. 0.80.

In conclusion, the maximum gain from the strategy is limited to the net premium earned of Rs. 10.80 and the maximum loss is capped at (Rs. 400 – Rs. 380 – Rs. 10.80) Rs. 9.20.

The iron butterfly options strategy primarily includes –

1. A combination of four options contracts with an identical expiration date.
2. Three types of strike prices are involved – upper, middle, and lower.
3. The bear call spread and bull put spread converge at the middle strike price.

How to use Iron Butterfly Strategy?

From the above example, it may be concluded that the iron butterfly strategy yields maximum profit when the option closes at the money indicating the price of the underlying is the same as the middle strike price. The nearer to the middle strike price the underlying closes at, the higher will be the profit. A loss is incurred if the underlying closes above the upper strike price or below the lower strike price. Thus, the iron butterfly strategy entails a clearly defined range within which profit is earned on an overall basis. If the price of the underlying closes beyond the range, then it is a loss.

Iron Butterfly is applicable in cases where the market volatility is comparatively lower. The sweet spot for the iron butterfly is narrow and profit is earned only in cases where the price of the underlying closes in the above-mentioned range. If the price of the underlying fluctuates drastically then the iron strategy fails.

Benefits of Iron Butterfly Strategy

Iron Butterfly Strategy provides various benefits.

Pre-defined profit and loss

The primary benefit of this strategy is that an investor can make an informed decision by analyzing the risk and reward involved.

Minimum capital required

An iron butterfly strategy can be executed with a relatively small amount of capital commitment. It provides steady income as compared to other directional spreads.

Opt-out if the range exceeds

A trader may opt to close out a portion of the position if the price of the underlying moves out of the defined range and continue to hold the remaining bull put or bear call spread. Alternatively, the trader also has an option to roll up or roll down the position to hedge the loss.

The iron butterfly options strategy is a useful tool for experienced traders and veterans. It is an appropriate substitute for spot trading in a low-volatility market.

Frequently Asked Questions

What is a short iron butterfly strategy?

Iron butterfly options strategy can be divided into two types – Long Iron Butterfly and Short Iron Butterfly. As explained above, a short iron butterfly involves buying a lower strike put, a higher strike call and selling a middle strike call and put. On the contrary, long iron butterfly requires selling a lower strike put, a higher strike call and buying a middle strike call and put. Thus, a short iron butterfly is a net credit strategy whereas a long iron butterfly is a net debit strategy.

How do you defend an Iron Butterfly strategy?

Iron Butterfly strategy can be defended by either settling a part of the position or by rolling it up or down based on the price movement of the underlying security.

Is the Iron Butterfly a good strategy for options trading?

The purpose of the iron butterfly is to provide steady income at limited risks. However, an investor must also factor in the cost of trading while analyzing the gain and loss from the position.

How to set up an iron butterfly?

To set up an iron butterfly strategy, sell an at-the-money (ATM) short straddle and buy out-of-the-money (OTM) options on both sides (wings). This creates a risk-defined position with limited profit potential, ideal for low-volatility markets

Is an iron butterfly better than an iron condor?

The iron butterfly strategy offers higher potential profits but limited risk compared to the iron condor. The choice depends on your market outlook and risk tolerance2. Both strategies benefit from low volatility, but the iron butterfly has a narrower profit range.