In today’s time derivative trading has rapidly grown to a great extent. People from all walks of life invest in the stock market but have a lack of knowledge in the subject of derivative trading.
Derivative trading in the stock market indicates the buying and selling of financial instruments whose value is derived from the value of an asset that is held under the contract. Examples of derivatives are the futures, options, swaps, and forwards. There are different types of derivative strategy which can be used in option trading. One of them is the Short & Long iron butterfly option strategy.
What Is A Short Iron Strategy?
The Short Iron Butterfly technique is applicable when an investor expects minimal or no change in the assets that are underpinning it. The reason for initiating it is the ability to correctly forecast the price of the stock until expiration time and benefit from time value. It’s a risk-free and a low reward strategy, which is similar to the Long Call Butterfly strategy. Short Iron Butterfly Short Iron Butterfly could also be viewed as a combination with Bear Call Spread and Bull Put Spread.
It is possible to say that the brief iron butterfly can be described as an unidirectional strategy. Option traders who wish to use this strategy should wait for the asset price to increase close to the middle value until the date of expiration. With this strategy, both profit and losses are capped. In addition, the maximum profit a trader could earn will be the base price which is precisely in the mid-strike and the maximum loss for traders can be incurred when the value falls lower or goes over the strike.
3 Benefits of Short Iron Butterfly option strategy
- The time decay benefits the position of the trader
- The chance of maximum loss is limited
- It is considered as a net credit option strategy.
2 Drawbacks of the strategy
- As the underlying price of asset reach near the middle strike price there is chance of high volatility which can harm trader position
- Suppose the underlying asset price moves against two breakeven points, there is a chance facing loss in the trade.
4 Key Points To Know About Short Iron Butterfly Option Strategy
- You need to make sure that there is a bearish trend in the market which will reduce price once you enter in the trade.
- The distance between the lower strike and middle strike price is equal to that between the middle strike
- You should also know that the wider the difference between the adjacent strikes, the larger will be the profit & vice versa.
- Lastly, you need to check that the asset has sufficient liquidity in the underlying which is being chosen to initiate the following option strategy.
Long Iron Butterfly Option Strategy
Long iron butterflies is a neutral option strategy which involves purchasing a combination of four different options having an expiration time of the same. It’s known as “iron butterfly” because the graph of profit and loss of this strategy appears like an iron butterfly’s wings.
This Is How The Iron Long Butterfly Operates:
- First, Sell a call option that is in the money.
- Purchase a cash-out call option with a greater strike price.
- You can sell a put option at the money
- Purchase a put option that is out-of-the-money which has a lesser strike.
Remember, Each of the future contracts should have the same expiration date.
3 Benefits of Long Iron Butterfly Option Strategy
It is a neutral strategy where the trader can profit from either direction whether the price goes up or down.
The loss in this strategy is limited
As per the market conditions the iron butterfly can be adjusted and customize accordingly
2 Drawbacks of Long Iron Butterfly Option Strategy
- The chances of loss is high than the potential reward
- Time decay can hurt the investment, as the position seems unprofitable.
4 Key Points To Know About Long Iron Butterfly Option Strategy
- You need to identify the neutral view on the price direction as well as the volatility should show a sharp movement as soon as you enter the position.
- Make sure that the distance between the lower strike price of the assets and middle strike is equal to the difference between the middle strike & the higher strike.
- You have to narrow the difference between the adjacent strike price, as the smaller will be the cost and the risk similar the reward will be and vice versa
- As the strategy is a range bound one, the benefits from rising the volatility will ensure that you execute this strategy when the expiration is far off which will also give the trader sufficient time to execute the trade.
Key Takeaway
The long iron butterfly is ideal for the time when you expect there will be sharp high or low movement of asset price. You must also know that the implied volatility of the underlying asset which you expect volatility might shoot up and you can apply the long butterfly strategy.
In the case of short iron butterfly strategy you can apply it when the expectation of stock remains within a specific range during a certain period. You can download an online share trading app to apply this strategy, Share India offers different options strategies to trade in the stock market.