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When investing, there are many different ways to bet your money and try to gain income or profit. Normal stock investing is simple but can be quite risky if you pick a loser. Using options can be a much less risky way to invest in the market.  Whereas investing in stocks can bring you great opportunities for profit, they also hold a large amount of risk. If you buy a stock and its price falls to 0, you lose everything that was invested.

In comparison, using a call or put on a stock can lower your total risk as well as be a much cheaper way to make profit. Using options allows investors to have the chance to reap large benefits without putting too much on the line.

Many people use simple call and put options, but there are numerous strategies that can be applied based on different situations and market expectations.

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The Iron Butterfly is an options strategy that consists of four different options. The technique will be demonstrated using options on Bank of America. For an Iron Butterfly, the investor:

  1.  Sells an at the money put
  2. Buys an out of the money put at a lower price than current price
  3.  Sells an at the money call
  4.  Buys an out of the money call at a higher price than current price.

This strategy is employed when the investor expects the stock to have low volatility but is not sure of the direction in which it will move. In this situation the investor would make the largest profit if the stock does not move much and would lose the most if the stock moves a lot in either direction.

Example – Bank of America

boa

For this example we will use Bank of America and their current options for May 20th, 2016. As of closing March 29th, 2016 the current price of BOA was $13.42. For ease, the price of BOA will be rounded down to $13.  We will use quantities of 1000 for each option.

 

  1. Buy put option with strike price of $11 for 08 cents a share ($80 output)

PUT11

2. Sell put option with strike price of  $13 for 43 cents a share ($430 input)

PUT13

3. Sell call option with a strike price of $13 for 84 cents a share ($840 input)

CALL13

4. Buy call option with a strike price of $15 for 12 cents a share ($120 output)

CALL15

Maximum Profit

The maximum profit for the investor would be obtained if the options expire at the current price. In this situation, there would be no loss as neither the sold call or put would be exercised (and the premium from the selling of these two options would be gained). The bought put and call would also expire worthless for the trader. However, the premiums paid to the trader would be more than the premiums that were paid for the bought options as it is more expensive to buy at the money as opposed to out of the money.

Based on these options, the investor performing the Iron Butterfly would have an income of $1,070 ($1,270-200) after initial transactions. If the price at the expiration date is $13 (ends at the money), then the profit attained is the maximum profit at $1,070.

Maximum Loss

As the price of the BOA stock moves away from $13 in either direction, the investor would lose money until the maximum loss of $930 is attained. This maximum loss first occurs at two points for the investor. It occurs at the price of $11 as the profits gained from the purchased put offsets the loss from the sold put for every cent moved, as well as at $15 where the profit from the purchased call offsets the losses occurred for the sold call.

TOTALPROF

Break Even Points

The investor in this situation would see profit at any point in-between the two break even points (BEP).

The upper breakeven point can be found by taking the strike price of the short call and adding the net premium received per share

  • $13+1.07 = $14.07

The lower breakeven point is found by taking the strike price of the short put and subtracting the net premium received per share.

  • $13-1.07 = $11.93

 

Between $11.93 and $14.07, the investor would make a profit in this situation. The Iron Butterfly is a bet used when the investor does not think there will be much volatility in the stock and can be a great way to take advantage of options. Although there is still a possible loss, this strategy hedges against much heavier losses that could be accumulated in other investments and is a much cheaper way to try and gain profit.