What is Iron Butterfly? How to Calculate Profit and Loss in Iron Butterfly Strategy?

Iron Butterfly can be considered as a Hedged Version of the Short Straddle Strategy. In our previous article we have discussed in detail about the Short Straddle, and we hope that you have an Idea of the same so as to get a better understanding of Iron Fly.

Iron Butterfly or Iron Fly is a Non Directional Option Strategy consisting of Four Legs, which can be used to capitalize a consolidating Market. In Short Straddle, we Sell both ATM Call and Put Option in the same quantities of the same expiry.

One of the major setbacks of Short Straddle is the Unlimited loss potential the Strategy has, if the market becomes trending in a directional manner and moves out of its Breakeven Points. Also Carrying Overnight Short Straddle positions has a higher risk as it could not handle huge Gap up and Gap down Openings.

An Iron Fly or Iron Butterfly, can be considered as a Hedged Short Straddle. In this Strategy we Sell Both ATM Call and Put Options, and at the same time to limit the losses an OTM Call as well as an OTM Put Option is bought.

The Buy legs on either side makes sure that the trade could handle directional moves of the market, or a Gap up or Gap Down. The loss of an Iron Fly is Fixed and it offers a good Risk to Reward Ratio. The unique combination of Higher Profits and Lower Loss makes Iron Fly a favourite Option Strategy of many traders. 

An Iron Fly Consists of the Following Trades,

1. An ATM Call Sell
2. An ATM Put Sell
3. An OTM Call Buy and 
4. An OTM Put Buy

The Key Parameters of an Iron Fly is calculated as Below,

Max Profit = Net Credit = Net Premium Collected

Upper Break Even = Call Sell Strike + Net Credit

Lower Break  Even = Put Sell Strike – Net Credit

Max Loss on Upper Side = Call Side Spread – Net Credit

Max Loss on Lower Side = Put Side Spread – Net Credit

The Below Payoff Graph will give you a better Idea of the Iron Fly.

When you analyse the Payoff Diagram, you could see that it’s similar to a Straddle, but maximum loss potential is limited in this trade. The OTM Call and Put Option Bought makes sure that the losses are limited when the Market moves outside our Profit zone. Also in an Iron Fly the risk to reward ratio is highly favourable to the trade.

Analysis

Let’s analyze the above trade in Detail. Assume that Nifty is at 17350 and based on analysis on the Market and economic conditions, we expect the market to consolidate within a range of 17200 to 17500.

With that view in mind to fetch the maximum Theta value we sell an ATM Call option at 130/- Rs Premium and an ATM Put Option at 130/- Rs Premium, collecting a combined Total of 260 Points Premium.

Here we don’t wish to keep our sell legs Open, as due to fear of any unknown events causing large directional moves in the market. So to Hedge our Sell Legs, we buy an OTM 17600 Call Option at a Premium of 35 and OTM 17100 Put Option at a Premium of 35.

For the Buy legs in Overall we have paid a Premium of 70/- Rs and from the Sell Legs we have collected a Premium of 260/- Rs, thereby a Net Premium of 260 – 70 = 190/- is collected while executing the trade. As there is a Net Credit of Premium in this Trade, Iron Fly falls under the Category of Net Credit Strategies.

Iron Fly also has Two Breakeven Points, an Upper Breakeven Point and a Lower Break Even Point, As the Net Credit of the Trade is 190 Points, an Upside move upto 190 points from the Call sell strike can be handled by the trade without going into losses. Thus the Upper Breakeven is 17350 + 190 = 17540.

Similarly a downside move of 190 Points from the Put Option Sell Strike won’t take the trade into loss by expiry, so the lower Breakeven point is 17350 – 190 = 17160.

In overall the Profit range of the Iron Fly is Between 17160 and 17540, which is a suitable trading range as per initial analysis of the market for the Expiry.  Our upper Breakeven point is 17540 and the Call Option Buy leg is at 17600, when the market moves above 17540, the trade Call sell leg will incur loss till 17600 Call Buy Leg. So the 60 Points is the maximum loss (60 x 50 = 3000/-) which could incur if the market goes beyond our range on the Upper side.

Similarly the Lower Side Breakeven is at 17160, and the Put Option Buy Leg is at 17100. If the Market moves below 17160 the Put Side will incur loss till the Buy leg at 17100.

So the maximum loss on the lower side if the market moves out of the breakeven on the lower side is the 60 Points Gap between the breakeven point and the Put buy leg ( 60 x 50 =3000/-). As we have maintained a 60 Points gap between the Breakeven point and the Hedge Buy Leg position of either side, the maximum loss on the trade is that 60 Points, equivalent to 60 x 50 = 3000/- Rs per lot. If the Market consolidates and Expires at the ATM strike of 17350, the trade could fetch the maximum profit by retaining the Net Premium collected 190, making a Maximum profit of 190 x 50 = 9500/- per lot.

As the Iron Fly Strategy is an Inherently Hedged Position, there is no need to Put additional Stop loss on the Sell Legs, this strategy could very well handle the market volatility and even if the market makes violent moves on any one direction the maximum loss either side is well defined on a favourable risk reward ratio. On a slightly higher vix range the ATM Options will get a Higher Premium, which will help to widen the breakeven points of the Iron Fly as well as could fetch higher returns.

The Payoff Table for Iron Fly

Put Side P/L	Put Buy Leg Premium	Put Sell Leg Premium	Put Buy Leg IV	Put Sell Leg IV	Nifty Spot at Expiry	Call Sell Leg IV	Call Buy Leg IV	Call Sell Leg Premium	Call Buy Leg Premium	Call Side P/L	Combined P/L of Iron Fly
-7750	-35	130	400	650	16700	0	0	130	-35	4750	-3000
-7750	-35	130	350	600	16750	0	0	130	-35	4750	-3000
-7750	-35	130	300	550	16800	0	0	130	-35	4750	-3000
-7750	-35	130	250	500	16850	0	0	130	-35	4750	-3000
-7750	-35	130	200	450	16900	0	0	130	-35	4750	-3000
-7750	-35	130	150	400	16950	0	0	130	-35	4750	-3000
-7750	-35	130	100	350	17000	0	0	130	-35	4750	-3000
-7750	-35	130	50	300	17050	0	0	130	-35	4750	-3000
-7750	-35	130	0	250	17100	0	0	130	-35	4750	-3000
-5250	-35	130	0	200	17150	0	0	130	-35	4750	-500
-2750	-35	130	0	150	17200	0	0	130	-35	4750	2000
-250	-35	130	0	100	17250	0	0	130	-35	4750	4500
2250	-35	130	0	50	17300	0	0	130	-35	4750	7000
4750	-35	130	0	0	17350	0	0	130	-35	4750	9500
4750	-35	130	0	0	17400	50	0	130	-35	2250	7000
4750	-35	130	0	0	17450	100	0	130	-35	-250	4500
4750	-35	130	0	0	17500	150	0	130	-35	-2750	2000
4750	-35	130	0	0	17550	200	0	130	-35	-5250	-500
4750	-35	130	0	0	17600	250	0	130	-35	-7750	-3000
4750	-35	130	0	0	17650	300	50	130	-35	-7750	-3000
4750	-35	130	0	0	17700	350	100	130	-35	-7750	-3000
4750	-35	130	0	0	17750	400	150	130	-35	-7750	-3000
4750	-35	130	0	0	17800	450	200	130	-35	-7750	-3000
4750	-35	130	0	0	17850	500	250	130	-35	-7750	-3000
4750	-35	130	0	0	17900	550	300	130	-35	-7750	-3000
4750	-35	130	0	0	17950	600	350	130	-35	-7750	-3000
4750	-35	130	0	0	18000	650	400	130	-35	-7750	-3000
4750	-35	130	0	0	18050	700	450	130	-35	-7750	-3000
4750	-35	130	0	0	18100	750	500	130	-35	-7750	-3000
4750	-35	130	0	0	18150	800	550	130	-35	-7750	-3000

From the Payoff Table and Graph, if you notice, even if the market moves up to any range above 17600 the maximum loss the trade could have is 3000/- same as the case on the put side if the market falls below 17100. This Limited loss and high Profit along with minimal MTM loss is a special characteristic of the Iron Butterfly.

Option adjustments techniques are there for Iron Fly also, which could even reduce the loss it could have in case of the directional market movement. Hope you have got a fairly good idea about the Iron Fly Strategy, In our upcoming articles we will be discussing similar Non Directional Strategies to capitalize the Consolidation phase of the Market.