How to Execute an Iron Butterfly Option Trade

12/27/2010 12:01 am EST

Focus: OPTIONS

Joseph Hargett

Financial Analyst, Schaeffer's Investment Research, Inc.

Apple Inc. (AAPL) has been the source of much speculation in the option pits lately, with the shares extending their recent string of all-time highs at the $325 level. Recently, AAPL puts were the talk of the town on the International Securities Exchange (ISE), though today's activity appears divided between both puts and calls. So far, more than 41,000 calls and 40,000 puts have changed hands, with call volume tracking at roughly 83% of the stock's daily average call activity, while put volume has come in at 122% of AAPL's average daily put activity.

Overall, AAPL's January 2011 310 and 330 puts and January 2011 330 and 350 calls are among the most active strikes on the session. Drilling down on this activity, we find that today's volume includes the entry of a larger spread position. In fact, a block of 100 contracts traded on each of the aforementioned four strikes at exactly 11:02 am eastern time on the International Securities Exchange (ISE) and were marked "spread", thus supporting the theory that this activity was initiated by the same trader.

Taking a closer look reveals that the January 2011 310 puts and the January 2011 350 calls traded at the ask prices of $5.89 and $1.30, respectively, while the January 2011 330 puts and the January 2011 330 calls changed hands at the bid prices of $3.51 and $11.72, respectively. Given this information, it would appear that we are looking at a potential iron butterfly on Apple Inc.


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The Anatomy of an Apple Inc. Iron Butterfly

What is an iron butterfly? Basically, this options trading strategy involves entering a bearish call credit spread and a bullish put credit spread. Much like a traditional credit spread, the goal for an iron butterfly is for all options involved to expire worthless, allowing the trader to retain the entire credit received at initiation. As a result, the objective is for these options to close out of the money, requiring the security to remain in a narrow trading range.

In AAPL's case, the trade breaks down like this: The trader paid $58,900 for 100 January 2011 310 puts and shelled out $13,000 for 100 January 2011 350 calls. Meanwhile, the trader received a credit of $35,100 by selling 100 January 2011 330 puts and pocketed another $117,200 by selling 100 January 2011 330 calls.

So, we have a bearish call spread between the January 2011 330 and 350 strikes, and a bullish put spread between the January 2011 310 and 330 strikes. At this point, the trader has banked a total credit of $80,400. The breakdown for this iron butterfly is listed below:


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Now, don't let this mass of calls and puts confuse you too much. The general principle of this AAPL iron butterfly is for the shares to close at $330 by the time the options expire. Such a finish would mean that all of the options involved expire worthless, thus allowing the trader to retain the entire premium.

The iron butterfly has two breakeven points. The first breakeven point of $321.96 is found by subtracting the premium received ($8.04) from the sold January 2011 330 put. The second breakeven point of $338.04 is arrived upon by adding the premium received ($8.04) to the sold January 2011 330 call.

The maximum gain is equal to the total premium received, which is $80,400. The maximum loss, in the event of a downside move, is limited to the difference between the January 2011 310 and 330 puts, minus the net credit received. In the event of an upside move, the maximum loss is limited to the difference between the January 2011 350 and 330 calls, minus the net credit received. In this case, the maximum loss is the same following a sharp move in either direction, with the trader losing out on $11.96, or $1,196 per contract [(330 - 310) - 8.04 = $11.96].

Below is a chart for a visual representation:


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Implied Volatility

After the iron butterfly position has been established, increasing implied volatility becomes a considerable liability. Still, the main concerns in this position are the sold January 2011 330 put and the sold January 2011 330 call. An increase in “implieds” for these options will increase their prices, making it much more expensive to exit the position should the trader need to buy these options back. Furthermore, since the whole point of an AAPL iron butterfly is for the stock to remain stable, rising implied volatility is also a negative as it suggests an increased possibility of a price swing for the shares.

By Joseph Hargett, contributor, Schaeffer’s Trading Floor Blog

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