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Options: The Iron Butterfly Strategy

|Includes: General Mills, Inc. (GIS)

The curiously-named "iron butterfly" is a complex strategy offering limited losses and limited profits. It is an expanded version of the basic butterfly (two separate spreads offsetting one another). The "iron" version is a combined straddle consisting of four options instead of the butterfly's three.

An iron butterfly can be either long or short. The long version consists of a long call and long put at the same strike; and a lower-strike short put plus higher-strike short call. For example, General Mills (NYSE:GIS) was worth $49.40 per share on August 3. At that price a long iron butterfly could be created with the following contracts:

Long 50 call @ 1.00

Long 50 put @ 1.60

Short 47.50 put @ -1.54

Short 51.50 call @ -0.45

Net credit = -0.61

In a short iron butterfly, the positions are reversed; for example for GIS a short iron butterfly could have been constructed with the following:

Short 50 put @ -1.54

Short 50 call @ -0.96

Long 47.50 put @ 0.57

Long 51.50 call @ 0.49

Net credit -1.44

In this case, you get $144 paid to you before trading fees. For some traders, the limits on both profit and loss are advantageous. However, this strategy ties up capital with margin requirements, and the farther away expiration is, the longer this applies. So the question should be whether this strategy is worth the limitations, not to mention the need to monitor constantly. If you are not sure about the current volatility of the market, an iron butterfly is a play that could make sense, long or short depending on which direction you believe the underlying is most likely to move, and to what degree.

Swing traders might also find iron butterflies attractive in some instances, although these traders are more likely to use single option contracts or synthetics to play the swings while holding down risk exposure. For most traders, the small window of possible profits make this strategy less attractive than many others.

Although evaluation of the iron butterfly is based on prices as expiration approaches, it's more realistic to expect positions to close as they become profitable. As long as short options are closed first or together with corresponding long options, the balance is maintained. However, if long options are closed first, two consequences occur. First, margin requirements increase; second, the exposure of short options replaces the previous long-short balance, taking risks much higher.

The collateral requirement for any butterfly generally is equal to the strike difference between long and short sides. To review how collateral works in this position or any other, download the free CBOE report at CBOE Margin Manual.

Michael Thomsett blogs at the CBOE Options Hub and several other sites. He is author of 11 options books and has been trading options for 35 years. Thomsett Publishing Website

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.