Iron Butterfly
Candlefocus EditorThe purpose of the butterfly strategy is to limit the potential losses while capitalizing on any gains potential within the range. If the stock's price remains within the range until the expiration date of the options, the trader would usually retain his/her maximum potential return, which should theoretically be the difference between the two premiums purchased minus commissions.
While generally very profitable and relatively low-risk, the Iron Butterfly trade can still be expensive due to the double premium price. In a low volatility environment, when the options don't move much in price, the cost of the trade could be greater than the reward. Furthermore, traders must also be aware of the consequences of holding the trade to expiration. If the underlying asset’s price moves through the strike prices, the trader will own the stock at the expiration thus losing the entire premium cost.
Overall, the Iron Butterfly trade is an excellent example of a strategy that is used to capitalize on a certain type of market environment. To be a successful trader, it is essential to understand the fundamentals behind this trade and be aware of all the potential risks. Experienced options traders can use the Iron Butterfly to benefit from price movement in a particular direction, while also limiting their risk exposure. Furthermore, the strategy can be used to take advantage of periods of declining implied volatility, thus helping minimize the cost of the options prior to the expiration date.