What are the characteristics of this option strategy?
Reverse iron butterfly spreads are the inverse of the iron butterfly and use four options in the same expiration: buying an at-the-money call and an at-the-money put, and selling an out-of-the-money call and an out-of-the-money put. The position is opened for a net debit, and that debit is the most that can be lost. It is a long volatility trade: it needs the underlying to move far enough in either direction to be worth more than the debit paid.
Is this a bullish, bearish or neutral strategy?
The Reverse Iron Butterfly Option Strategy is direction neutral but long volatility. You do not need to be right about which way the underlying goes, only that it moves. The short out-of-the-money call and put are there to cheapen the long straddle, and they cap the profit once the underlying trades past them. The entire net debit is lost if the underlying finishes at the middle strike.
Is this a beginner or an advanced option strategy?
This option strategy is best suited for intermediate to advanced traders with experience in understanding the complex workings of options and the underlying assets.
In what situation will I use this strategy?
This strategy is most effective when a large move is expected but the direction is not, for example ahead of an earnings report, a court ruling or a trial result. It is not a range-bound trade. The underlying has to travel past one of the breakeven points for the position to make money, and the short wings mean the payoff stops growing once it reaches them.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
Risk is defined on both sides. The maximum loss is the net debit paid, and the maximum profit is the distance from the middle strike out to a wing, minus that debit. The probability of profit is low to moderate, because the underlying has to move past a breakeven point rather than simply sit still. Losing part or all of the debit is the most common outcome.
How is this strategy affected by the greeks?
This strategy is affected by the option greeks of Delta, Theta, Vega, and Gamma. Delta represents the rate of change of an option’s price relative to the underlying stock’s price. Theta represents the rate of time decay of an option’s price. Vega represents the sensitivity of the option’s price to changes in implied volatility. Gamma represents the rate of change of an option’s price relative to changes in the underlying stock’s price.
In what volatility regime (i.e VIX level) would this strategy be optimal?
The Reverse Iron Butterfly Option Strategy needs the underlying to move a long way before expiration, so what matters is the size of the expected move relative to the debit paid, not the VIX level on its own. The favorable case is entering when implied volatility is cheap and realized volatility then rises. There is no VIX threshold that makes this trade profitable by itself.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
Adjustments are limited, because the trade goes against you by nothing happening. The realistic choices are closing early to recover whatever time value is left in the long options, buying back a short wing to uncap the profit on the side the underlying is moving toward (which costs money and raises the maximum loss), or rolling the whole structure out to a later expiration for a further debit. None of these turns a stalled position into a winner on its own.
Where does this strategy typically fall in the range of commissions and fees?
The commissions and fees associated with this option strategy can vary from broker to broker, but typically it falls in the middle range.
Is this a good option income strategy?
The Reverse Iron Butterfly Option Strategy is not an income strategy: it is paid for with a net debit, loses value to time decay each day, and only pays off if the underlying makes a large move before expiration.
How do I know when to exit this strategy?
Most traders close this position for whatever it is worth rather than holding it to expiration, because the long at-the-money options bleed time value every day the underlying stays put. The usual exits are taking profit once the underlying has traded past a short strike and the spread is near its maximum value, or cutting the trade once a meaningful share of the debit has decayed and the expected move has not arrived.
How will market makers respond to this trade being opened?
Market makers will typically set prices for option transactions in which they believe they will profit. Therefore, when opening a position with a market maker, it is important to check the pricing of the options and the implied volatility before executing the trade.
What is an example (with calculations) of this strategy?
Assuming MSFT is trading at $285, an investor can create a Reverse Iron Butterfly Option Strategy with four options that all share the same expiration date: a long call and a long put at the middle strike, and a short call and a short put out at the wings.
To execute this strategy, the investor would do the following:
Buy one call option with a strike price of $285 and an expiration date of one month from now, paying a premium of $8 per share.
Buy one put option with a strike price of $285 and the same expiration one month from now, paying a premium of $8 per share.
Sell one out-of-the-money call with a strike price of $305, expiring on the same date one month from now, receiving a premium of $2 per share.
Sell one out-of-the-money put with a strike price of $265, expiring on the same date one month from now, receiving a premium of $2 per share.
The net debit is $8 + $8 - $2 - $2 = $12 per share, or $1,200 for one contract of each leg. Every short strike is covered by a long option at $285, so that debit is the entire risk of the position.
The resulting payoff diagram is an iron butterfly turned upside down: the long options sit at the center and the short options sit at the wings, so the worst outcome is in the middle and the profit is made out at the edges.
Here’s how the strategy works:
If MSFT's price is exactly $285 at expiration, all four options expire worthless and the investor loses the entire $12 per share net debit ($1,200), which is the maximum loss for this strategy.
The breakevens are $273 ($285 minus the $12 debit) and $297 ($285 plus the $12 debit). Between those two prices the trade loses money, and outside them it makes money.
If MSFT finishes at or above $305, or at or below $265, the position is at its maximum profit of $8 per share ($20 from the middle strike out to the wing, minus the $12 debit), or $800 per contract. The short wings cap the gain from there on but they do not create a loss.
No matter how far MSFT moves in either direction, the long $285 call and put sit inside the short strikes, so the loss can never exceed the $12 net debit.
MarketXLS
For traders looking to capitalize on options trading strategies, MarketXLS is an invaluable tool. It provides actionable options data with easy-to-use options analysis tools. With MarketXLS, traders can quickly analyze positions, monitor performance, and create custom spreads and strategies. With the real-time paper trading feature, you can practice and test your strategies before putting them in action. All of this combined with high quality data and a user friendly interface makes MarketXLS the go-to platform for advanced option traders.
Here are some templates that you can use to create your own models
Reverse Iron Butterfly Spread
Reverse Iron Albatross Spread
Search for all Templates here: https://marketxls.com/templates/
Relevant blogs that you can read to learn more about the topic
Are Butterfly Spreads Right for You?
Reverse Iron Butterfly Options Strategy (Using MarketXLS Template)