What is an iron butterfly?

The iron butterfly is an intricate options trading strategy executed by combining two vertical spreads—specifically, a bull put spread and a bear call spread—employing options contracts of the same expiration date but differing strike prices. This strategy is designed to capitalize on anticipated minimal price movement and low volatility in the underlying asset.

Traders typically initiate an iron butterfly by simultaneously selling an at-the-money call option and an at-the-money put option while purchasing an out-of-the-money call option and an out-of-the-money put option. The goal is to create a profit zone between the two strike prices, allowing traders to profit from the asset’s price staying within a specific range until the options expire.

The maximum profit potential of an iron butterfly occurs when the underlying asset’s price remains stable and settles precisely at the middle strike price upon expiration. Traders anticipate gains from the time decay of the options and a reduction in implied volatility, which can contribute to profitability.

However, while this strategy offers a limited-risk profile due to the built-in spreads, potential losses can arise if the asset’s price deviates significantly beyond the range established by the strike prices. Therefore, traders must monitor market conditions closely to adjust their positions accordingly and mitigate risks.