Options trading iron butterfly
Thus, this is a limited loss, and, limited profit strategy. Max Loss for the Iron Butterfly would occur in either of these two scenarios: This strategy should be executed when the trader expects the volatility to be low. The idea behind this strategy is to earn as much premium as possible on the sold options. With the passage of time, option premiums decay; and, hence the best time to execute this strategy would be at least two to three days before the expiry; for weekly options — this is not a strict rule though; and, the trader needs to consider the volatility.
Remember to execute this strategy on a stock which has high liquidity, as the trader runs the risk of assignment on the sold options.
An options trader constructs an iron butterfly by: All the options expiry worthless, and the trader gains the entire Net Premium received. This is the maximum profit the trader can make. All the options except the May 50 Put sold expire worthless. All the options except the May 50 Call sold expire worthless. Increase in volatility, everything else being the same, would have a negative impact on this strategy.
The passage of time, everything else being the same, would have a positive impact on this strategy. Should this happen, the trader can decide to either close out the resulting position in the market or to exercise one of the options Put or Call — as the case be.
For this strategy, time decay is your friend. Ideally, you want all of the options in this spread to expire worthless with the stock precisely at strike B. After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices. If your forecast was correct and the stock price is at or around strike B, you want volatility to decrease. Your main concern is the two options you sold at strike B.
A decrease in implied volatility will cause those near-the-money options to decrease in value. So the overall value of the butterfly will decrease, making it less expensive to close your position.
In addition, you want the stock price to remain stable around strike B, and a decrease in implied volatility suggests that may be the case. If your forecast was incorrect and the stock price is below strike A or above strike C, in general you want volatility to increase.
This is especially true as expiration approaches. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike B. So the overall value of the iron butterfly will decrease, making it less expensive to close your position. Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options.
Options investors may lose the entire amount of their investment in a relatively short period of time. Multiple leg options strategies involve additional risks , and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point.
The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract.
There is no guarantee that the forecasts of implied volatility or the Greeks will be correct. Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. System response and access times may vary due to market conditions, system performance, and other factors. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy.
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