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What is Iron Butterfly Strategy?

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The Iron Butterfly options strategy is an options trading strategy used to profit from low volatility in the underlying asset. It’s a combination of two vertical spreads, the call spread, and the put spread, resulting in a position that resembles the shape of a butterfly. Here’s how it works:

 

What is Iron Butterfly Strategy?

 

Call Spread: In an Iron Butterfly, you simultaneously sell an out-of-the-money (OTM) call option and buy a further OTM call option. This creates a bearish call spread that profits when the underlying asset remains below a certain strike price.

Put Spread: Similarly, you sell an OTM put option and buy a further OTM put option. This establishes a bullish put spread that profits when the underlying asset stays above a certain strike price.

The Iron Butterfly strategy’s unique characteristic is that the short-call and short-put options are at the same strike price, typically at the current market price of the underlying asset. This is often referred to as the “body” of the butterfly.

The goal of the Iron Butterfly strategy is to capitalize on low market volatility. It profits when the underlying asset stays close to the central strike price (the body), resulting in the options expiring worthless. Maximum profit is achieved when the underlying asset closes at the body’s strike price upon expiration.

Conversely, the Iron Butterfly carries limited profit potential and capped losses if the market experiences significant price movement. It’s a strategy suited for traders who anticipate a period of stability in the underlying asset but want to be protected from extreme price swings.

How to Use the Iron Butterfly

The Iron Butterfly Strategy is ideal for traders expecting low market volatility and a stable price range for the underlying asset. To implement this butterfly strategy, select an underlying asset and its expiration date. Sell an at-the-money call and put option to collect premiums, while buying an out-of-the-money call and put options as protection against extreme price movements. This setup creates a defined profit zone, where gains are maximised if the price remains near the strike price of the sold options. The iron fly strategy provides limited risk and rewards, making it an effective choice for range-bound markets. In India, the premiums collected and potential profits are calculated in ₹, offering traders a clear risk-reward picture.

Types of Butterfly Option Strategy

The butterfly trading strategy has multiple variations, including the Iron Butterfly Strategy, Reverse Iron Butterfly Spread, Long Call Butterfly Spread, Long Put Butterfly Spread, Short Call Butterfly Spread, and Short Put Butterfly Spread.

Long Call Butterfly Spread

  1. Definition: Combines buying one in-the-money call, selling two at-the-money calls, and buying one out-of-the-money call.
  2. Objective: Profits if the underlying price remains near the middle strike price at expiration.
  3. Best Use: For low volatility markets where a stock is expected to stay near a specific level.
  4. Example: ₹1,000 strike price, ₹1,050 middle strike, and ₹1,100 call.

Long Put Butterfly Spread

  1. Definition: Involves buying one in-the-money put, selling two at-the-money puts, and buying one out-of-the-money put.
  2. Objective: Gains from price stability, specifically when the stock price is near the middle strike.
  3. Best Use: Effective in downward-moving markets with limited volatility.
  4. Example: ₹900 in-the-money, ₹950 at-the-money, and ₹1,000 out-of-the-money puts.

Short Call Butterfly Spread

  1. Definition: Sells one in-the-money call, buys two at-the-money calls, and sells one out-of-the-money call.
  2. Objective: Profits from high volatility when the price moves significantly beyond the outer strikes.
  3. Best Use: Ideal for high volatility stocks.
  4. Example: ₹1,200 strike price, ₹1,250 middle strike, and ₹1,300 out-of-the-money call.

Short Put Butterfly Spread

  1. Definition: Sells one in-the-money put, buys two at-the-money puts, and sells one out-of-the-money put.
  2. Objective: Gains from a wide range of price movements, especially downward volatility.
  3. Best Use: Suitable for volatile bearish markets.
  4. Example: ₹800 in-the-money, ₹850 at-the-money, and ₹900 out-of-the-money put.

Iron Butterfly Options Strategy

  1. Definition: Combines selling an at-the-money call and put while buying out-of-the-money call and put options.
  2. Objective: Profits when the underlying stock price stays within the range defined by the sold options.
  3. Risk/Reward: Limited risk and capped profit potential.
  4. Example: ₹1,000 at-the-money and ₹900/₹1,100 out-of-the-money strikes.

Reverse Iron Butterfly Spread

  1. Definition: Involves buying an at-the-money call and put while selling out-of-the-money call and put options.
  2. Objective: Gains from increased volatility, benefiting when the price moves significantly away from the middle strike.
  3. Best Use: Ideal for volatile markets with sharp price movements.
  4. Example: ₹950 at-the-money call/put and ₹900/₹1,000 out-of-the-money strikes.

Who Should Use The Iron Butterfly Strategy

The Iron Butterfly options strategy is best suited for traders and investors with a specific set of expectations and risk tolerance. Here are some considerations for those who should use the Iron Fly strategy:

Low Volatility Expectations: This strategy is ideal for those who anticipate a period of low volatility in the underlying asset. It’s designed to profit from minimal price movement.

Income Generation: Traders looking to generate income in a low-volatility market can use the Iron Butterfly to collect premiums from selling options.

Neutral Outlook: If you have a neutral or non-directional view of the underlying asset and believe it will stay within a specific price range, the Iron Butterfly can be a suitable strategy.

Limited Risk Tolerance: The Iron fly has limited risk because the maximum loss is defined, making it attractive for risk-averse traders. However, potential profits are also limited.

Options Experience: Traders with experience in options strategies and an understanding of how options work may find the Iron Fly strategy more suitable. It involves both call and put options, which require a good grasp of options trading principles.

Hedging Existing Positions: It can be used as a hedging strategy to protect an existing position. If you have an open position and want to limit potential losses within a specific range, an Iron fly can help achieve that.

Patience: This strategy requires patience, as it benefits from the passage of time and the decay of option premiums. Traders should be prepared to hold the position until options expire.

It’s essential to thoroughly understand the risks and rewards of the Iron Fly and to carefully consider the market conditions and your outlook before implementing this strategy. Additionally, it’s advisable to use risk management techniques, like setting stop-loss orders, to protect against unexpected market movements.

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When Should An Investor Use The  Iron Butterfly Strategy

Expectation of Low Volatility: When an investor anticipates a period of low price volatility in the underlying asset, the Iron Butterfly can be used to profit from the lack of significant price movements.

Generating Income: Investors looking to generate income from their portfolio can employ the Iron Butterfly to collect premiums by selling options. This strategy allows them to benefit from time decay.

Neutral Market Outlook: If an investor holds a neutral or non-directional view of the underlying asset and believes it will remain within a certain price range, the Iron Fly strategy can be an effective strategy to capitalize on this expectation.

Limited Risk Tolerance: Investors with a low-risk tolerance may find the Iron Butterfly attractive because it has well-defined and limited maximum losses. However, it also has capped profit potential.

Risk Management: As a hedging strategy, the Iron Butterfly can be used to protect an existing position. Investors may employ it to limit potential losses within a specified range, especially when they have an open position that they want to safeguard.

Experience with Options: Investors who are experienced with options trading and understand the mechanics of both call and put options are better suited for the Iron Butterfly. A solid knowledge of options is essential for implementing this strategy effectively.

Also Read: Covered Call Option Strategy

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Advantages and Disadvantages of the Iron Butterfly Strategy

The Iron Butterfly strategy, like any options strategy, comes with its own set of advantages and disadvantages:

Advantages:

Profit from Low Volatility: The Iron Butterfly is designed to profit from low volatility in the underlying asset. When the market remains relatively stable, the strategy can generate consistent income.

Limited Risk: The maximum risk is well-defined and limited to the initial investment, which makes it suitable for risk-averse traders and investors.

Limited Capital Requirement: Compared to some other options strategies, the Iron Butterfly typically requires less capital to establish, as it involves selling both calls and put options to collect premiums.

Income Generation: This strategy can provide a steady stream of income through the premiums collected from selling options, especially when market conditions are conducive.

Defined Profit Range: The Iron Butterfly has a clearly defined profit range, making it easier for traders to set realistic expectations.

Disadvantages:

Limited Profit Potential: The profit potential is also capped, and it’s generally lower than the maximum potential loss. This makes it less attractive for those seeking high returns.

Time Decay: While time decay can work in your favour, it can also erode the value of the options you’re holding. If the market doesn’t move as expected, you may experience losses due to time decay.

Complexity: The Iron Butterfly strategy involves multiple options positions, both calls and puts, which can be complex for those who are new to options trading.

Commissions and Fees: Trading options can be associated with commissions and fees, which can impact the overall profitability of the strategy.

Market Movement Risk: The strategy relies on the underlying asset staying within a specific price range. If the market makes significant moves outside of this range, it can lead to losses.

Potential for Assignment: Options can be assigned at any time, and if one leg of the Iron Butterfly is assigned, it can disrupt the strategy and potentially result in unwanted positions.

Also Read:  itm call option

Conclusion

In conclusion, the Iron Butterfly strategy is a versatile options trading approach suited for traders and investors seeking to profit from low market volatility and generate income. It offers a defined risk-reward profile, making it attractive to risk-averse individuals. While it provides a structured way to capitalize on neutral market expectations, its limited profit potential and reliance on time decay should be noted. This strategy’s success hinges on accurately predicting low volatility and the underlying asset staying within a specified range. It’s best employed by those with experience in options trading and the patience to manage it through time decay. Careful consideration of market conditions and risk tolerance is essential before implementing the Iron Butterfly.

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Frequently Asked Questions

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When should I use a butterfly strategy?

Answer Field

A butterfly strategy is ideal when you anticipate low market volatility and expect the underlying asset's price to remain range-bound. This butterfly trading strategy works best in flat or stable market conditions where significant price movements are unlikely.

What are the different types of butterfly strategies?

Answer Field

The butterfly trading strategy includes several variations, such as the call butterfly, put butterfly, and iron fly strategy. The iron butterfly option strategy, or iron butterfly spread, is a popular choice, combining call and put options to profit from minimal price movement.

How does time decay impact a butterfly strategy?

Answer Field

Time decay can benefit a butterfly strategy if the underlying asset’s price remains close to the middle strike price. However, if the price moves significantly, time decay may erode potential gains rapidly, particularly in strategies like the iron butterfly option.

What are the maximum profit and loss in a butterfly strategy?

Answer Field

The maximum profit in a butterfly trading strategy is limited to the net premium received from selling the options. Maximum loss occurs if the asset’s price moves beyond the outer strike prices, making risk management crucial in an iron butterfly option strategy.

Can I use a butterfly strategy on Indian stocks?

Answer Field

Yes, you can use the butterfly strategy, including the iron butterfly option strategy, on Indian stocks. Strategies like the iron butterfly spread are available for Indian equity derivatives, provided the underlying stock or index has liquid options markets.

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Bajaj Financial Securities Limited ("Bajaj Broking" or "Research Entity") is regulated by the Securities and Exchange Board of India ("SEBI") and is licensed to carry on the business of broking, depository services and related activities.  

This Report has been prepared by Bajaj Financial Securities Limited in the capacity of a Research Analyst having SEBI Registration No. INH000010043 and distributed as per SEBI (Research Analysts) Regulations 2014. This report does not constitute an offer or solicitation for the purchase or sale of any financial instrument or as an official confirmation of any transaction. The information contained herein is from publicly available data or other sources believed to be reliable. This report is provided for assistance only and is not intended to be and must not alone be taken as the basis for an investment decision. The user assumes the entire risk of any use made of this information. Each recipient of this report should make such investigation as it deems necessary to arrive at an independent evaluation of an investment in the securities of companies referred to in this document (including the merits and risks involved), and should consult his own advisors to determine the merits and risks of such investment. The investment discussed or views expressed may not be suitable for all investors.  

This information is strictly confidential and is being furnished to you solely for your information. This information should not be reproduced or redistributed or passed on directly or indirectly in any form to any other person or published, copied, in whole or in part, for any purpose. This report is not directed or intended for distribution to, or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction, where such distribution, publication, availability or use would be contrary to law, regulation or which would subject Bajaj Financial Securities Limited and associates / group companies to any registration or licensing requirements within such jurisdiction. The distribution of this report in certain jurisdictions may be restricted by law, and persons in whose possession this report comes, should observe, any such restrictions. The information given in this report is as of the date of this report and there can be no assurance that future results or events will be consistent with this information. This information is subject to change without any prior notice. Bajaj Financial Securities Limited reserves the right to make modifications and alterations to this statement as may be required from time to time. Bajaj Financial Securities Limited or any of its associates / group companies shall not be in any way responsible for any loss or damage that may arise to any person from any inadvertent error in the information contained in this report. Bajaj Financial Securities Limited is committed to providing independent and transparent recommendation to its clients. Neither Bajaj Financial Securities Limited nor any of its associates, group companies, directors, employees, agents or representatives shall be liable for any damages whether direct, indirect, special or consequential including loss of revenue or lost profits that may arise from or in connection with the use of the information. Our proprietary trading and investment businesses may make investment decisions that are inconsistent with the recommendations expressed herein. Past performance is not necessarily a guide to future performance .The disclosures of interest statements incorporated in this report are provided solely to enhance the transparency and should not be treated as endorsement of the views expressed in the report. The information provided in these reports remains, unless otherwise stated, the copyright of Bajaj Financial Securities Limited. All layout, design, original artwork, concepts and other Intellectual Properties, remains the property and copyright of Bajaj Financial Securities Limited and may not be used in any form or for any purpose whatsoever by any party without the express written permission of the copyright holders.  

We offer our research services to clients as well as our prospects. Though this report is disseminated to all the customers simultaneously, not all customers may receive this report at the same time. We will not treat recipients as customers by virtue of their receiving this report.  

Bajaj Financial Securities Limited and its associates, officer, directors, and employees, research analyst (including relatives) worldwide may: (a) from time to time, have long or short positions in, and buy or sell the securities thereof, of company(ies), mentioned herein or (b) be engaged in any other transaction involving such securities and earn brokerage or other compensation or act as a market maker in the financial instruments of the subject company/company(ies) discussed herein or act as advisor or lender/borrower to such company(ies) or have other potential/material conflict of interest with respect to any recommendation and related information and opinions at the time of publication of research report or at the time of public appearance. Bajaj Financial Securities Limited may have proprietary long/short position in the above-mentioned scrip(s) and therefore should be considered as interested. The views provided herein are general in nature and do not consider risk appetite or investment objective of any particular investor; readers are requested to take independent professional advice before investing. This should not be construed as invitation or solicitation to do business with Bajaj Financial Securities Limited.  

Bajaj Financial Securities Limited or its associates may have received compensation from the subject company in the past 12 months. Bajaj Financial Securities Limited or its associates may have managed or co-managed public offering of securities for the subject company in the past 12 months. Bajaj Financial Securities Limited or its associates may have received compensation for investment banking or merchant banking or brokerage services from the subject company in the past 12 months. Bajaj Financial Securities Limited or its associates may have received any compensation for products or services other than investment banking or merchant banking or brokerage services from the subject company in the past 12 months. Bajaj Financial Securities Limited or its associates have not received any compensation or other benefits from the Subject Company or third party in connection with the research report. Research analyst or his/her relative or Bajaj Financial Securities Limited’s associates may have financial interest in the subject company. Bajaj Financial Securities Limited, its associates, research analyst and his/her relative may have other potential/material conflict of interest with respect to any recommendation and related information and opinions at the time of publication of research report or at the time of public appearance.  

Research analyst has served as an officer, director or employee of subject Company: No  

Bajaj Financial Securities Limited has financial interest in the subject companies: No  

Bajaj Financial Securities Limited’s Associates may have actual/beneficial ownership of 1% or more securities of the subject company at the end of the month immediately preceding the date of publication of research report.  

Research analyst or his/her relative has actual/beneficial ownership of 1% or more securities of the subject company at the end of the month immediately preceding the date of publication of research report: No  

Bajaj Financial Securities Limited has actual/beneficial ownership of 1% or more securities of the subject company at the end of the month immediately preceding the date of publication of research report: No  

Subject company may have been client during twelve months preceding the date of distribution of the research report.  

There were no instances of non-compliance by Bajaj Financial Securities Limited on any matter related to the capital markets, resulting in significant and material disciplinary action during the last three years. A graph of daily closing prices of the securities is also available at https://www.nseindia.com/

ANALYST CERTIFICATION

The analyst for this report certifies that all of the views expressed in this report accurately reflect his or her personal views about the subject company or companies and its or their securities, and no part of his or her compensation was, is or will be, directly or indirectly related to specific recommendations or views expressed in this report.  

RISK DISCLOSURE ON DERIVATIVES

  • 9 out of 10 individual traders in equity Futures and Options Segment, incurred net losses.
  • On an average, loss makers registered net trading loss close to ₹ 50,000.
  • Over and above the net trading losses incurred, loss makers expended an additional 28% of net trading losses as transaction costs.
  • Those making net trading profits, incurred between 15% to 50% of such profits as transaction cost.

SEBI study dated January 25, 2023 on “Analysis of Profit and Loss of Individual Traders dealing in equity Futures and Options (F&O) Segment”, wherein Aggregate Level findings are based on annual Profit/Loss incurred by individual traders in equity F&O during FY 2021-22.

BROKERAGE DISCLAIMER

All leveraged intraday positions will be squared off on the same day. There is no restriction on the withdrawal of the unutilised margin amount. Brokerage will not exceed the SEBI prescribed limit. Visit : https://www.bajajbroking.in/pricing

MTF 

As subject to the provisions of SEBI Circular CIR/MRD/DP/54/2017 dated June 13, 2017, and the terms and conditions mentioned in the lights and obligations statement issued by the TM (if applicable).  

US INVESTING

International investment is not supervised by any regulatory body in India. Thus, any claim or dispute relating to such investment or enforcement of any agreement/contract /claim will not be under laws and regulations of the recognized stock exchanges and investor protection under Indian Securities Law. The account opening process will be carried out on Vested platform and Bajaj Financial Securities Limited will not have any role in it.  

MARKETSMITH / GOLDENPI / SOVEREIGN GOLD BONDS

Bajaj Financial Securities Limited is only distributor of this product. These are not exchange traded products and all disputes with respect to the distribution activity, would not have access to exchange investor redressal forum or Arbitration mechanism. Bajaj Financial Securities Limited is not a registered Investment Advisory. User discretion is required before investing. Client is requested to independently evaluate and/or consult their professional advisors before arriving at any conclusion to make any investment. The decision to invest shall be the sole responsibility of the Client and shall not hold Bajaj Financial Securities Limited, its employees and associates responsible for any losses, damages of any type whatsoever. 

IPO 

This should not be construed as soliciting investment. Investors’ discretion is required. Kindly consult your financial expert before investing. No need to issue cheques by investors while subscribing to IPO. Investments in securities markets are subject to market risks, read all the related documents carefully before investing.  

SCREENERS 

Screeners is not Exchange-approved products and any disputes related to the same will not be dealt on the Exchange platform. 

SECURITIES 

Securities quoted are exemplary and not recommendatory. 

IPV 

Account would be open after all procedure relating to IPV and client due diligence is completed. 

IMAGES 

The images used are only for representation purpose. Proper due diligence has been done for the images and the image is not of any artist. The same is captured from royalty free sites. 

DISCLOSURE TO CLIENTS REGARDING PAYOUT OF FUNDS

As per SEBI circular no. SEBI/HO/MIRSD/MIRSD-PoD-1/P/CIR/2023/84 dated June 08, 2023, Stockbrokers are required to upstream the entire client funds lying with them to the Clearing Corporation. Based on client’s request the funds’ release request must be placed with the Clearing Corporation. Based on the internal process and cut-off timelines of the Clearing Corporation the funds will be released to the Stock Broker. In view of this new process, as specified by the regulatory and the cut-off time of Clearing Corporation/Banks processing the funds, Bajaj Financial Securities Limited cannot commit the exact time for releasing funds payout to its client. Clients are requested to note that, Bajaj Financial Securities Limited will not be responsible for any inconvenience caused to clients due to delay in release of funds payout, including fines, delayed charges, defaults, etc.