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Short Iron Butterfly

A Short Iron Butterfly is a multi-legged option strategy consisting of calls and puts. There are two short options (one call and one put) at the middle strike with one long call option at a higher strike and one long put option at a lower strike. The interval between the higher strike and middle strike is equal to the interval between the middle strike and lower strike. Expirations for each strike are the same. This trade results in a net premium received (credit) upon initial order entry.

Short Iron Butterfly

Uses

The option trader who uses this strategy has a neutral outlook and expects the underlying security to close at the middle strike at expiration.

Risks

This strategy is considered to have limited risk and limited reward. The maximum gain occurs when the stock price closes at the short strike price by expiration. The maximum gain amount is equal to the amount of premium received (credit) upon initial order entry. Maximum loss is calculated by taking the interval (high strike to middle strike or middle strike to low strike) and subtracting the premium received upon initial order entry. The maximum loss occurs if the stock price falls below the lower strike or rises above the higher strike by expiration.

Steady movement up (or down) causing the underlying stock to trade away from the middle strike will result in a decrease in strategy value.

Increasing implied volatility can have a negative impact on this strategy. Option traders electing to close the position before expiration could be impacted by increasing implied volatility.

Time decay has a positive effect on this strategy.

Options traders have assignment and exercise risk on this trade. Early assignment (American Style) is a possibility when the short strikes are in-the-money. Also, the option trader runs the risk of uncertainty on assignment when the underlying security is close to the short middle strike. This situation also results in the middle strikes still having some time premium on the last day of trading prior to expiration. The option trader should be aware of these risks prior to implementing this strategy.


Important Note: Options involve risk and are not suitable for all investors. For more information, please read the Characteristics and Risks of Standardized Options.

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