The Reverse Iron Butterfly Spread is a limited profit, limited loss options trading strategy that is designed to make some profit when the underlying stock price makes a sharp upward or downward movement. A Reverse Iron Butterfly is a neutral and multi-leg strategy with limited profit potential. The strategy looks to take advantage from a rise in volatility and large price movement in the underlying asset. It is one of the most advanced strategies, including four transactions with both puts and calls.
Reverse Iron Butterfly is essentially a long straddle with short options sold out-of-the-money that reduce the position’s cost basis but limits the profit scope. A trader would initiate a Reverse Iron Butterfly when he believes that the stock price will make a large movement in either direction before expiration and implied volatility will increase.
Reverse Iron Butterfly has no bias for either of the directions but requires a significant movement in the underlying price to exceed the break-even price.
Reverse Iron Butterfly Spread Construction
- Selling 1 OTM Put
- Buying 1 ATM Put
- Buying 1 ATM Call
- Selling 1 OTM Call
To implement a Reverse Iron Butterfly, the trader sells a lower strike out-of-the-money put, buys a middle strike at-the-money call, buys another middle strike at-the-money put and sells another higher strike out-of-the-money call. There will be a net debit taken to set up the trade.
The spreads between strike prices can be of any width. Lesser premium will be paid when the width of the spread is more between the short option and the long option, but the risk will be higher.
Maximum profit for the Reverse Iron Butterfly is limited and is achieved when the underlying stock price rises above or equal to the strike price of the short call option or drops below or equal to the strike price of the short put option.
The formula for calculating maximum profit is:
- Max Profit is achieved When Price of Underlying >= Strike Price of Short Call or Price of Underlying <= Strike Price of Short Put
- Max Profit = Strike Price of Long Put (or Short Call) – Strike Price of Short Put (or Long Call) – Net Premium Paid – Commissions Paid
Maximum loss for the Reverse Iron Butterfly is also limited. It occurs when the underlying stock price at expiration is equal to the strike price of the long put and the long call options. At this price, all the options expire worthless and the options trader suffers a loss equal to the initial debit taken while entering the trade.
The formula for calculating maximum loss is:
- Max Loss Occurs When Price of Underlying = Strike Price of Long Put/Call
- Max Loss = Net Premium Paid + Commissions Paid
There are 2 break-even points for the Reverse Iron Butterfly position:
Lower Breakeven Point = Strike Price of Long Put – Net Premium Paid
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Applying Reverse Iron Butterfly Spread Using MarketXLS Template With an Example:
MarketXLS software is a one-stop solution for the analysis of your entire investments. It provides a host of functions like eps, various ratios, key fundamentals, historical data, options pricing and much more to assess the value of your investments. It provides a variety of templates for various options trading strategies and also to compare your portfolio stocks for doing a better analysis of your investments.
Step 1: Enter the stock ticker in cell D6 and press enter. The template will provide the upcoming expiry dates for the stock and the current market price. Select any one of the expiry dates.
Link to the Template: https://marketxls.com/template/reverse-iron-butterfly-spread/
Step 2: Enter the ATM Strike price for Put and Call buy option in cell D12.
Step 3: Enter the OTM Strike price for Put option in cell D14 and for Call option in cell D16.
Step 4: The template might ask you to refresh. Go to the MarketXLS tab in the ribbon > Refresh All. Click on Refresh All.
The template uses the bid price for sells and ask price for buys to calculate the amount of premium to be paid by you.
Step 5: The template also provides the Net Payoff Profile of the strategy. You need to enter the expected minimum and maximum expiry prices for the period. It will calculate the net profit or net loss for all the levels of expiry prices for all the options positions and present it graphically.
Microsoft Corporation (MSFT) as an example in the above template:
MSFT stock is trading at levels of $289 on 27th July, 2021. I have selected the upcoming expiry of 20th August 2021 to enter the trade. I believe that the stock can make sharp movement in either of the directions and so I executed a Reverse Iron Butterfly strategy by Buying an ATM Call and Put option @$290, selling an OTM Put option @$270, and selling another OTM Call option @$310.
The template will calculate the premium amounts for all the options and thus calculate the net cash flow for entering the trade, which is $1088 debit in this case.
[ 1.56*100 ($270 strike) – 7.3*100 ($290 Put strike) – 5.8*100 ($290 Call strike) + 0.66*100 ($310 strike) = -$1088]
Suppose if the stock keeps trading at levels of $290 on expiration, all the 4 options will expire worthless and I will suffer a loss equal to the initial debit taken 0f $1088 (10.88*100 lot) while entering the trade, which is also my maximum possible loss.
If the stock is trading at $270 on expiration, all the options expire worthless except the Long Put option. This option will have an intrinsic value of $2000. Subtracting the initial $1088 debit taken to enter the trade, my profit will be $912 (9.12*100 lot), which is also my maximum possible profit.
If the stock is trading at $310 on expiration, only the Long Call option will expire in money with an intrinsic value of $2000. Subtracting the initial $1088 debit taken to enter the trade, my profit again comes to $912 (9.12*100 lot).
To further see why $912 is the maximum possible profit for this position let’s examine what happens when the stock price falls below $270 to $260 on expiration. At this price, only the Short Put and the Long Put options expire in the money. The Short Put has an intrinsic value of $1000 while the Long Put is worth $3000. Selling the Long Put for $3000 to buy back the Short Put at $1000 and factoring in the initial debit of $1088 taken upon entering the trade, I will again be left with $912 in profits. This maximum profit situation also occurs if the stock price had gone up to $320 or beyond instead.
Here is a video explaining Reverse Iron Butterfly Strategy Using MarketXLS:
The Reverse Iron Butterfly Spread needs the price of the underlying asset to move a certain amount in either direction in order to make a profit, or else the strategy will result in a loss if the price doesn’t move enough. The written options limit the profit of the trade even if the price of the underlying asset makes a significant move in either direction. In the absence of the written options, the trade stands to make a potentially larger profit. A Reverse Iron Butterfly without the written options is also known as a long straddle.
One of the advantages of this strategy is that one can calculate the exact break-even points at the time of initiating the spread. The Reverse Iron Butterfly spread is a debit spread and is a viable strategy if you are unable to create credit spreads.
The disadvantage is that it’s a complex strategy, and not just because of the four transactions involved, but also because the commission charges can be quite high due to the number of transactions.
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