Iron Butterfly

Weight-lifting technique? Kama Sutra entry? Nope...would you believe options strategy?

Yup. It's the name given to a particular combination of options meant to take advantage of low volatility. (It's also the name of a heavy metal band, but we're not going to talk about them here.)

First, a bit of background. Options give you the right, but not the obligation, to buy or sell some underlying asset at a set price at some point in the future. So...you buy an option to purchase 100 shares of MSFT at $140, with the option expiring in two months. If MSFT rises above $140 by the expiration date, you can exercise the option and immediately bank the profit. If the stock ends up at $135, you just let the option expire unused. You're only out the price of the option.

The basic (sometimes called "vanilla") options are puts and calls. Puts are bets that the price of the underlying option will go down. Calls are bets that the price will go up. By combining puts and calls in certain ways, an investor can profit from very specific scenarios. Such is the Iron Butterfly.

The Iron Butterfly involves four option contracts: two puts and two calls. Each of them has the same expiration, but they involve three different strike prices. In the strategy, you're selling a put and a call, while simultaneously buying a put and a call.

Example:

You buy a put with a strike price below the current trading price of the underlying asset. MSFT is trading at $125; you buy a put for $115. If MSFT drops below $115, this bet will pay off. At the same time, you sell a put with a strike price around the current trading price of the underlying asset. So...you sell a put for MSFT at $125. Also, you sell a call at the current price. One call sold for MSFT at $125. Lastly, you buy a call with a stock price above the current strike price. That means purchasing a call for MSFT at $135. This bet pays off if MSFT rises above $135.

Again, all these options have the same expiration date. The put and the call you bought are known as the butterfly's wings. They're meant to protect against big swings in the stock's price. If shares rise about $135, the call you bought pays off. If shares fall below $115, you can cash in the put.

When you buy the put and the call, you have to shell out cash. But because they're out-of-the-money (far away from the current trading price), they're relatively cheap. Meanwhile, when you sell the put and the call, you bring cash in. You are selling them, so you actually bring in money at the time you set the position. What's more, those options bring in more than you spent on the put and call you bought setting up the butterfly's wings. At the time you set the position, you earned a net credit.

The issue is that you're now potentially on the hook for those options you sold. The person you sold them to could cash them in. That's why you buy the multiple options for the Iron Butterfly strategy. The other options provide a series of hedges against that situation.

Your hope with an Iron Butterfly is that the stock doesn't move at all. You want MSFT to hold as close to $125 as possible. At that point, all four options expire without getting exercised, and you'll pocket the money you earned from selling the put and the call (minus the amount you paid for the out-of-money put and call you bought).

There's a variant of the Iron Butterfly known as the Long Iron Butterfly. (The structure we described above is sometimes called a Short Iron Butterfly). In the Long Iron Butterfly, you sell the put and call on the wings and buy the put and call in the middle. Same basic setup, just reversing which options are bought and which are sold. Not to be confused with the Long Island Butterfly, which is, uh...more for the weekend.