Many strategies exist in the world of stock option trading. There are the simple trades such as the long call or the long put that are common among beginners. And there are slightly more complicated trades that are still popular, such as the bull put and bear call spreads. And then there are the more esoteric and obscure trades, such as the often misunderstood iron butterfly, which is a great trade to generate maximum income.
To understand the iron butterfly trade, you have to start with the bull put spread, a credit spread that optimizes a rising stock price. The bull put is typically placed well underneath a stock that you think will rise, or at least not fall. The opposite of a bull put spread is the bear call spread which optimizes a falling market. If you apply a bull put spread under a stock and at the same time apply the bear call above the stock price, you are asking the stock to stay in a channel between your options. This becomes a four-legged trade called the iron condor. It is made up of long put, short put, short call, and long call.
If you set up a very wide channel, with your options far from the stock price, your profit might be in the range of 10% in a month. If you make the channel narrower, you might target 25% in a month. You can continue to make the channel narrower still and target 100% in a month. Sure that sounds attractive, but the likelihood of the stock staying in a narrow channel until expiration is low. With a narrow channel iron condor, chances are you will lose money.
But what if you make the channel width zero, that is, you place the short strike of your bull put at the same strike as the short strike of your bear call. The profit potential is massive, but the odds are very, very low. Let’s try an example. As I write this, April 5 weekly options on Apple (AAPL) have 12 days until expiration. AAPL looks like it is in a slight uptrend and might get to 470 in a week. So I will place a paper trade with an iron butterfly at 470. I will Buy 465 Put, Sell a 470 Put, Sell a 470 Call and Buy a 475 Call. The entire trade gives me a net credit of $4.62. With $5 wide strikes, that makes my maximum risk $38 (5.00-4.62). If AAPL closes at 470 a week from Friday, I will make $462 on a risk of only $38 for a gain of 1200% in 12 days.
But of course the odds of that happening are low. Not out of the question, but just low. However, the better way to trade this is to target a percentage gain – perhaps 25%. If AAPL is between 460 and 480 on Monday of expiration week, you have a good chance of getting that 25%. The trick is to not hold out for the ten-bagger. Just take your 25% and run. That’s how you play the Iron Butterfly for maximum income.
Submitted By: John Marsland
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