Reverse Iron Butterfly Spread

| April 20, 2012 | 0 Comments

iron butterfly spreadThe reverse iron butterfly spread is a complex, debit spread strategy which benefits from movement in the underlying instrument.  It’s similar in concept to a short butterfly spread, except it’s a debit spread.  A trader profits from a reverse iron butterfly spread when the underlying stock rallies or sells off.

A reverse iron butterfly spread is made up of four options trades at once, or two options spreads (a call and a put spread).  Both calls and puts are used in the reverse iron butterfly.  If executed properly, this strategy has limited maximum loss potential, but also capped gains.

Because you’re selling options as part of the reverse iron butterfly spread (you receive money for doing it), the entire strategy is cheaper than many other options strategies.  Basically, selling options as part of the spread helps offset cost of the options you buy.

Let’s take a closer look at the options in a reverse iron butterfly spread…

As mentioned earlier, the reverse iron butterfly spread is made up of four option trades, or two spreads.  For one reverse iron butterfly spread, you sell one out-of-the-money (OTM) call and buy one at-the-money (ATM) call (the call spread), and sell one OTM put and buy one ATM put (the put spread).  It’s important to note, the ATM put and call are the same strike.

The choice on which OTM call and put you sell depends on if you expect the underlying stock to climb or drop outside a certain range.  However, the OTM strikes will each be the same distance from the ATM strike.

Let’s look at an example…

Stock XYZ is trading at $50 per share.  Let’s say it’s November and you think XYZ is going to trade below $49 or above $51 in the next couple of months.  To put on one January 49-50-51 reverse iron butterfly spread, here’s what you’d do…

  • Sell one Jan 49 Put
  • Buy one Jan 50 Put
  • Sell one Jan 51 Call
  • Buy one Jan 50 Call

Now, let’s add theoretical prices to these options so we can calculate profit/loss potential.

  • Sell one Jan 49 Put for $0.65
  • Buy one Jan 50 Put for $1.00
  • Sell one Jan 51 Call for $0.65
  • Buy one Jan 50 Call for $1.00

The total cost to you is $0.70 per spread ($1.00 + $1.00 – $0.65 – $0.65).

Remember, you expect XYZ to trade above or below the $49-$51 range, so at or beyond either one of the OTM strikes, plus the cost of the spread, you will achieve profit.  So, your lower breakeven is $48.30 (the 49 strike minus $0.70 spread cost).  The upper breakeven is $51.70 (the 51 strike plus $0.70 spread cost).

Your maximum profit on this reverse iron butterfly is $0.30 per spread.  That’s the distance between the OTM options and the ATM options ($1.00) minus the cost of the spread ($0.70).

You lose money on this trade if XYZ closes between the OTM strikes plus/minus the cost of the spread (above$48.30 or under $51.70) on January expiration.  Keep in mind, your maximum loss is the cost of the spread.  So you can’t lose more than $0.70 per spread.

Remember, this a good strategy if you expect XYZ to move beyond either OTM strike by January expiration, and your broker won’t allow you to put on credit spreads (like a short butterfly spread).

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Category: Options Trading Strategies

About the Author ()

A former banking executive, Corey Williams is the Chief Options Strategist and co-editor of our well-known daily newsletter, Options Trading Research. Corey’s extensive experience with options goes all the way back to his days in corporate finance. It was this decade in banking where Corey discovered the most important skill an options trader can have– the ability to analyze a company or sector to determine its likely future direction. And now he’s brought this background, experience and love of options to Options Trading Research, the unique daily e-letter devoted exclusively to helping individual investors profit from the very lucrative options market.