CHAPTER 7

The 1-2-3 Iron Butterfly

The butterfly spread is referred to as a “neutral” strategy combing a bull and bear spread with the same expiration date. It involves three different strikes and four options. The normal configuration involves two short options at the middle strike, and long options above and below. Either puts or calls can be used to create a butterfly spread.

The Iron Butterfly

The iron butterfly is an expansion of the butterfly, involving both calls and puts. For example, a long put is opened below the middle and a long call above, and the middle strike involves a short put and a short call.

For example, Altria closed on April 25, 2019 at $51.41 and you purchased 100 shares. On that date, an iron butterfly spread consisting of both calls and puts could have been opened with the following (adjusted by $5 for trading fee):

This position yields a net credit after trading drees. It has the potential to create limited maximum profits in exchange for minimum exposure to loss. Examining the outcome as of expiration at various underlying prices makes this point as summarized in Table 7.1.

Table 7.1 Altria iron butterfly

Strike*	May 3 (8 days)	Premium	May 24 (29 days)	Premium	Jun 21 (57 days)	Premium
50	1 put	0.38	2 puts	-1.30	3 puts	4.78
51	1 put	-0.48	2 puts	2.66	3 puts	-7.70**
52.50	1 call	-0.25	2 calls	2.20	3 calls	-3.80
53	1 call	0.28	2 calls	-1.14	3 calls	1.93***
Total		-0.07		2.42		-4.79
Net						-2.44

* Purchased options are increased to allow for fees, and are reflected at ask price. Sold options are decreased to allow for fees, and are reflected at bid price.

** June 51 put not available, premium reflects price of 7.70 for 52.50 puts.

*** June 53 call not available, premium reflects price of 1.93 for 55 calls.

This outcome reveals that if all positions were kept open to expiration, most price levels would realize a net loss of $72. Only at $51 per share would the minimal profit be realized. In practice, however, positions would not be held open until expiration, but closed as profits materialize.

A similar strategy is the condor, involving four strikes rather than three. Ideally, the underlying should be priced in the middle so that two options are opened below and two above. A short condor would consist of middle strike long and lower/upper strike short positions, just like the butterfly.

Many traders avoid butterflies and iron butterflies due to the limited profit potential. A conservative trader may be willing to accept limited profits in exchange for limited losses, but this limitation is difficult to overcome when trading costs are considered. Given the number of contracts (four) and trading costs at entry and at exit, there are a total of eight charges. A solution would be to open multiple contracts, or to expand the iron butterfly into a hedge with the idea of taking profits well before expiration. This is where the 1-2-3 iron butterfly comes into the picture.

The 1-2-3 Iron Butterfly Concept

Considering the commissions involved with a butterfly of any type, traders need to take one of two precautions. First, you must ensure that the net credit is adequate to cover trading costs while still producing potential profits. Second, it makes sense in some instances to open multiple contracts to efficiently reduce the trading costs. Brokers charge a minimum fee for the option trade and a very small additional fee for additional options. For example, the minimum fee may be $5.75, plus 0.75 for each option. The trading cost to enter and again to exit would be:

1. option $5.75 + 0.75 = $6.50
2. options $5.75 + 1.50 = $7.25
3. options $5.75 + 2.25 = $8.00
4. options $5.75 + 3.00 = $8.75

For one option the transaction cost is $6.50, but for four options the average per option is reduced to $2.19 each ($8.75 ÷ 4).

The cost of trading is a considerable factor and cannot be overlooked. For this reason alone, traders may want to involve multiple contracts rather than single contracts. However, for purposes of comparison and explanation, single-option examples are provided; however, these vary considerably by broker and by the number of contracts.

The 1-2-3 iron butterfly consists of three separate iron butterflies, one in each of the next three expiration periods. However, if the underlying stock also pays a dividend, it is smart not to open positions during ex-dividend month to avoid the risk of early exercise. If the company pays a dividend in October and January, the 1-2-3 iron butterfly may be set up using November, December, and February.

The 1-2-3 iron butterfly—like the regular iron butterfly—is a combination of OTM and ATM strikes, or at least close to the money. It combines puts and calls. The 1-2-3 refers to two attributes. First is the user of three expiration months. Second is the increased number of contracts at each expiration. The first expiring month involves one option at each strike, then two, and then three. Other increments can be used as well, such as 2-4-6 or 3-6-9, for example.

Another distinguishing feature of the 1-2-3 iron butterfly is that the middle month is a reverse iron butterfly, meaning the lower put and upper call are both short, and the two ATM middle strikes are long. This is done to set up a hedge matrix, the offset of profits in both calls and puts in three months. This hedge matrix enables you to close options in one, two, or three of the expiration months at a profit, no matter which direction the stock moves:

1. If the underlying price rises, long calls and short puts will become profitable in all three periods.
2. If the underlying price falls, long puts and short calls will become profitable in all three periods.
3. If the underlying price remains at or close to the initial entry price, all short options will lose time value and become profitable.

It does not guarantee that all positions will become profitable in all instances. This is where rolling forward is a smarty recovery strategy. Invariably, after closing most positions at a profit, a few positions remain open. These positions, whether long or short, can be closed at a loss and replaced with later-expiring long or short options. These leftover positions (“orphans”) can be used to create a reconstituted 1-2-3 iron butterfly. This is necessary when the underlying has moved far above or below the strike range of the original options. These leftover positions are closed and replaced with new, later-expiring positions closer in range to the underlying price. Thus, the 1-2-3 iron butterfly can evolve with a stock whose price is moving, by carrying losses forward and adjusting the basis in new options.

For example, if your original long positions would lose $200 if closed today, but these are rolled forward and replaced with new options costing $300, the adjusted long basis is $500 ($200 loss carried forward plus $300 paid for the new long options). If the original short positions would lose $300 if closed today, but these are rolled forward and replaced with new options yielding $400, the net basis is $100 ($400 for selling new options minus $300 loss on the previous contracts).

Rolling forward works for both long and short sides. However, this also makes it more difficult to create a net profit later because of the adjustment in the net basis. This disadvantage is often offset by the faster profit accumulation because new strikes are closer to the current underlying price. The 1-2-3 is a complex set of transactions and should be used only by traders thoroughly familiar and experienced with options.

The Hedge Matrix and Collateral Requirements

The hedge matrix serves two purposes. First, it sets up a situation in which you can take profits, no matter what occurs in the underlying price. Second, it keeps collateral requirements at a minimum.

Collateral for uncovered short options is equal to 20 percent of the strike value minus premium received. For example, an uncovered 97.50 call or put must be accompanied by collateral of $1,950 ($9,750 * 20% = $1,950) minus option premium received. To calculate required margin for short positions, use the free margin calculator offered by the CBOE:

http://cboe.com/trading-tools/calculators/margin-calculator

You can also download a free Margin Manual to discover how margin requirements vary by type of option:

http://cboe.com/LearnCenter/pdf/margin2-00.pdf

Example of the Strategy

The 1-2-3 iron butterfly can be set up for any stock; however, it makes sense to also avoid the ex-dividend month to prevent early exercise. Any time a short call is ITM, you are at risk of early exercise in the ex-dividend month. This does not mean it will always happen, but it is a possibility. Having open short calls in the following month avoids this risk, because time value in the call will normally make early exercise impractical.

For a long call owner to justify early exercise, the combination of any capital gain plus dividend income must be greater than the cost of that call. Early exercise is most likely on the day before ex-dividend date. So even if a short call that is ITM is only marginally at risk, it may still get exercised if the long call holder would realize a capital gain. In that case, the gain plus dividend would create a very nice profit.

An example of the strategy follows, shown in Table 7.1, for Altria (MO). Ex-dividend months are January, April, July, and October. Based on the values on April 25, 2019, the following 1-2-3 iron butterfly could be opened, setting up an overall net credit.

Some explanations: Since not every option strike will be available at every expiration, this table has some adjusted strikes in use, in two instances. These occur in the last section, the June 21 options. The 51 put was not available, so three contracts were traded on the 52.50 put strike. The 53 call strike was not available, so three contracts were traded on the 55 call strike.

Although this changes the consistency of the 1-2-3 iron butterfly, the symmetry of the strategy is kept intact. The overall net credit yielded was 2.44 ($244). This would be the net realized value if all options expired worthless, which is unlikely because some positions will always be in the money. A more likely outcome would be to close positions when they become profitable and attempt to offset long and short positions.

The potential to offset one set of strikes against others with different expiration dates may cause a higher collateral requirement to go into effect. Any trader writing a 1-2-3 iron butterfly must be prepared to deposit additional funds in the event that short positions are left open for any one expiration without offsetting long positions.

The 1-2-3 iron butterfly and its hedge matrix can be applied to many different strategies that combine options to set up neutral outcomes or outcomes of net credits. By involving three separate expiration months, you can take the benefit of offsetting long and short positions to limit risk, while closing short and long positions together when profits materialize.

The next chapter explores another conservative strategy, the dividend collar. This is designed to eliminate market risk in the stock, while setting up option positions to earn dividends every month (instead of every quarter). This creates a double-digit dividend yield by moving in and out of positions in ex-dividend month.

Class questions for discussion and/or mini-case studies

1. The iron butterfly is a multipart strategy consisting of:

   a. Certainty of profits due to the hedging features involved.

   b. Inflexible space between strikes.

   c. Long and short positions, including both calls and puts.

   d. All calls or all puts, but not a combination of both.

2. The condor is like the butterfly, with the exception that:

   a. Incremental strikes are farther apart.

   b. Four strikes are involved rather than three.

   c. Several different expiration dates are spread out to exploit time decay.

   d. No collateral is required due to the structure that is set up.

3. The hedge matrix describes:

   a. Combinations of long and short options over several expiration dates.

   b. The use of similar or identical strikes but multiple expiration dates.

   c. Combinations of butterflies, condors, and other strategies opened simultaneously.

   d. An impossible situation for profits, due to offsetting ITM and OTM positions.

Discussion

Select a company and its stock and set up an example of the 1-2-3 iron butterfly. Examine profit potential based on offsetting long and short positions and the overall net credit.