What Is an Iron Butterfly Spread?

An iron butterfly spread is an options trading strategy designed to profit from an underlying asset’s price remaining within a narrow range. This strategy is market-neutral, meaning it does not rely on significant price movement, and is suited for environments where low volatility is anticipated. It is also a defined risk strategy, where the maximum potential loss is known and limited at trade initiation.

Components of an Iron Butterfly Spread

An iron butterfly spread is constructed using four distinct options contracts, all sharing the same expiration date and underlying asset. These contracts involve both call and put options, strategically placed at different strike prices relative to the underlying asset’s current market price. An option is At-the-Money (ATM) if its strike price is equal or very close to the current underlying price. An option is Out-of-the-Money (OTM) if it has no intrinsic value; for a call, its strike price is above the current market price, and for a put, its strike price is below the current market price.

The core of the iron butterfly involves selling both an ATM call option and an ATM put option at the same strike price. These two sold options form the “body” of the butterfly. Simultaneously, two OTM options are purchased to provide risk protection, acting as the “wings.” Specifically, an OTM call option is bought with a strike price higher than the ATM call, and an OTM put option is bought with a strike price lower than the ATM put.

Constructing an Iron Butterfly Spread

This strategy begins by selling a call option and a put option, both At-the-Money (ATM) or very close to the current underlying asset price, and both having the same strike price and expiration date. This initial action generates a net credit, as premiums are received from selling these options. For example, if a stock is trading at $100, an investor would sell the $100 call and the $100 put.

To define the maximum risk, protective “wings” are added. This involves buying an Out-of-the-Money (OTM) call option with a higher strike price and an OTM put option with a lower strike price, both sharing the same expiration date as the sold options. For instance, if the stock is at $100, the investor might buy the $105 call and the $95 put.

The net effect of these four transactions is a credit received, as premiums from selling the ATM options typically exceed the cost of buying the OTM options. This initial credit represents the maximum potential profit for the strategy. The spread width between the inner (sold) and outer (bought) strike prices determines the extent of the risk-defined range.

Understanding Profit and Loss

Maximum Profit

The financial outcomes of an iron butterfly spread are defined at trade initiation, offering clear maximum profit and loss scenarios. This strategy benefits most when the underlying asset’s price remains stable and closes exactly at the strike price of the short options at expiration. In this ideal scenario, all four options expire worthless, and the maximum profit achieved is equal to the initial net credit received. For instance, if an investor received a net credit of $2.50 per share (or $250 for one contract of 100 shares), this $250 would be the maximum profit.

Maximum Loss

The maximum potential loss for an iron butterfly spread is limited due to the purchase of the protective OTM options. This loss occurs if the underlying asset’s price moves significantly above the strike price of the long call or significantly below the strike price of the long put at expiration. The maximum loss is calculated as the difference between adjacent strike prices (the spread width) minus the net credit received. For example, if the difference between the short and long call strike is $5, and a net credit of $2.50 was received, the maximum loss would be $2.50 ($5 – $2.50) per share, or $250 per contract.

Breakeven Points

An iron butterfly has two breakeven points, marking the boundaries of the profitable zone. The upper breakeven point is calculated by adding the net credit received to the strike price of the short call. The lower breakeven point is found by subtracting the net credit received from the strike price of the short put. Using our example with a $100 short call/put strike and a $2.50 net credit, the upper breakeven would be $102.50 ($100 + $2.50), and the lower breakeven would be $97.50 ($100 – $2.50). The strategy yields a profit if the underlying asset’s price at expiration falls anywhere between these two breakeven points. This defined profit range highlights the strategy’s reliance on limited price movement and declining implied volatility to be successful.