How to Limit Your Risk with Iron Butterflies – Part 1
In a recent article, we discussed straddles and strangles.
If you missed that piece, you can find it here.
Long straddles are profitable when the price of the underlying instrument moves significantly away from the strike price of the options before expiration. The maximum loss from a long straddle is the premium you paid for the long call and put options.
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In contrast, short straddles are profitable when the underlying price does not move significantly away from the strike price. However, the potential loss from a short straddle is unlimited, which significantly diminishes its attractiveness from a practical trading standpoint.
The good news is that we can easily limit the short straddle’s risk by turning it into an iron butterfly. To do this, we simply buy an Out-of-The-Money (OTM) call and an OTM put to add to the straddle’s At The Money (ATM) short call and short put. Now your maximum risk on the trade is the distance between the short strike and the long strike (this is typically the same on both the call and the put side), less the premium you received for putting on the trade.
Consider the risk profiles below:
The red lines show the risk profile for a short straddle. Notice how the lines slope down indefinitely and never level out; that’s the unlimited loss aspect of short straddles.
The purple lines show the risk profile for an iron butterfly whose protective long strikes are wide apart. As with the short straddle, the maximum profit of the butterfly occurs if the stock price is equal to the short middle strike at expiration. However, with a wide butterfly, the maximum profit is slightly lower than the straddle, because you’ve given up some of the premium collected on the short strikes to buy the far OTM long strikes.
The blue lines show the risk profile for a narrower iron butterfly. Here the long strikes are closer to the short strikes. The result is that the max potential loss is smaller (the “wings” are not as far below the breakeven line as for the wide butterfly), but the max profit is also smaller than either the wide butterfly or the short straddle. In essence, you’ve paid more for the “insurance” that limits your losses. In addition, there is a narrower range of prices over which
you will be profitable.
Incidentally, you can create the same risk profile using four call options or four put options. When all the options are of the same type, the overall position is referred to as a butterfly. When the position consists of a long and short put combined with a long and short call, it’s called an iron butterfly. In all cases, you short two options at the middle strike, and buy the options at the outside strikes.
In Part 2 we’ll address some of the issues to consider when selecting the strike prices for the long call and put options.