The derivatives market offers plenty of profitable opportunities during all types of market movements. In short durations, you can amplify gains using the right trading methods. However, the risk is also high. Different exclusive trading strategies can be applied to options trading.

One such unique trading technique is the iron butterfly options strategy, where the trading involves creating four different contracts to profit from the price movements. This blog delves deep into this strategy to explain how it is helpful in markets where underlying securities are no longer volatile.

The iron butterfly strategy is a spread strategy. It creates four contracts using the bull put spread and a bear call spread with identical expiration dates. These converge at the middle strike price. A short call and put are sold at the middle strike price. This forms the body of the butterfly. Again, call and put are purchased above and below the middle strike price. These form the wings of the butterfly.

This strategy is known for defined risks. It is ideal when the market remains neutral with little volatility. When the expiry date of options approaches, the underlying securities remain bound by the range. In such market conditions, the iron butterfly strategy can generate profits.

Such a strategy will earn you profit when there is minimal fluctuation and closes at the middle strike price. However, you may lose when the market fluctuates and closes above or below the middle strike price.

When the market conditions indicate that the price may be outside of the two breakeven points, opt for an alternative long-iron butterfly strategy.

The Iron Butterfly aims to offer a small profit when the underlying assets have low volatility. Due to limited reward, the risk is also limited. To use this strategy, the below steps are to be followed:

This strategy works only for assets with low volatility. So, look for assets that are more likely to stay within a tight price range.

Based on your speculation on low volatility, you must select the expiration date. This is crucial because the options automatically expire. A weekly iron butterfly strategy can be used if you expect the prices to remain stable for the week.

The underlying asset's spot price or current price should be your reference point for the strike price. This will help you determine the out-of-the-money (OTM) thresholds.

Now, you must open four options contracts:

- Sell an ATM Call
- Sell an ATM Put
- Buy an OTM Call
- Buy an OTM Put

You will start with a credit.

When the asset closes near the ATM strike price at the time of expiry, it will expire worthless, and you can realise the maximum profit.

However, when the asset gets closer to OTM strikes, you must change the position to minimise loss. You may buy back the sold options or let the bought options be executed.

When the underlying asset moves significantly in either direction, it will result in loss. So, continuous monitoring will help you adjust your positions. Sometimes, exiting early can reduce your losses.

To compute profits from the iron butterfly strategy, you must subtract the buying OTM options from the total premium from selling ATM options. The loss is the difference between your ATM strike, call/put OTM strike, and the net premium.

Let's break down the iron butterfly strategy with an example. Imagine the shares of XYZ Corporation are trading at Rs 200. You anticipate the shares to remain within a specific range in the coming month; so you opt for the iron butterfly strategy.

- You sell a Call Option with a strike price of Rs 200 and for a premium of Rs 25.
- You sell a Put Option with a strike price of Rs 200 and for a premium of Rs 25.
- You buy a Call Option with a strike price of Rs 220 and at a premium of Rs. 15.
- You buy a Put Option with a strike price of Rs 180 and at a premium of Rs 15.

Assuming each option has a lot size of 1,000 shares, your initial gain would be Rs [(25 x 1,000 + 25 x 1,000) – (15 x 1,000 + 15 x 1,000)], which equals Rs 20,000. This means you start with a net profit.

If the share price remains stable and closes at the middle strike price of Rs 200, all four options will expire worthless since the buyers wouldn't exercise their rights to buy or sell. In this scenario, you retain your initial profit of Rs 20,000.

However, a loss may occur if the share price closes below Rs 180 or above Rs 220. In such cases, the call or put buyer might exercise their rights. The greater the market volatility, the larger your potential loss.

The iron butterfly options strategy is one of the advanced options trading strategies requiring you to create four options contracts with precise speculated values. While it has a high probability of earning a limited profit, there is also a limited risk. It is ideal when you expect little to no price movements of the underlying assets.

Maximum profits are realised when the stock price closes close to the ATM strike. If not, all you can do is find a way to minimise the losses by closing or exiting at the right time.

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