The inverse iron butterfly is also sometimes referred to as an inverse short butterfly or a long butterfly. This is a volatility-based options strategy that aims to profit from a significant price movement in the underlying asset, either to the upside or the downside, by the time the options expire. It’s the opposite of the more common iron butterfly, which profits from price consolidation.

Core Concept:

The inverse iron butterfly is constructed by combining four options contracts with the same expiration date but four different strike prices. It involves:

1. Buying one out-of-the-money (OTM) put option with a lower strike price. This is the lower “wing” of the butterfly.
2. Selling one in-the-money (ITM) put option with a higher strike price. This is the lower body of the butterfly.
3. Selling one in-the-money (ITM) call option with a lower strike price (equal to the higher put strike). This is the upper body of the butterfly.
4. Buying one out-of-the-money (OTM) call option with a higher strike price. This is the upper “wing” of the butterfly.

These four strike prices are equidistant from each other. The two middle strikes (the short put and the short call) are typically centered around the current price of the underlying asset.

Construction Example:

Suppose the underlying asset is trading at $50. A typical inverse iron butterfly might be constructed with the following options, all with the same expiration date:

• Buy 1 Put Option with a $45 strike price.
• Sell 1 Put Option with a $50 strike price.
• Sell 1 Call Option with a $50 strike price.
• Buy 1 Call Option with a $55 strike price.

Net Debit:

Establishing an inverse iron butterfly typically results in a net debit, meaning you pay more to buy the two out-of-the-money options than you receive from selling the two in-the-money options. This net debit represents the maximum potential loss of the strategy (excluding brokerage commissions).

Profit and Loss Profile:

The profit and loss diagram of an inverse iron butterfly resembles an inverted tent or an “M” shape.

• Maximum Potential Profit: Occurs when the price of the underlying asset moves significantly away from the central strikes ($50 in our example) in either direction, landing at or beyond either of the outer strike prices ($45 on the downside or $55 on the upside) at expiration. The maximum profit is limited and is calculated as the difference between the width of the “wings” (the distance between the strikes) minus the initial net debit. In our example, the width of each “wing” from the center is $5. So the maximum profit would be $5 (upper) + $5 (lower) – net debit.

• Maximum Potential Loss: Limited to the initial net debit paid to establish the spread. This occurs if the price of the underlying asset expires exactly at the two middle strike prices ($50 in our example).

• Breakeven Points: There are typically two breakeven points for an inverse iron butterfly, one below the lower short put strike and one above the higher short call strike. These points are calculated by adding/subtracting the initial net debit from the respective short strike prices. In our example, if the net debit was $2, the lower breakeven would be $50 – $2 = $48, and the upper breakeven would be $50 + $2 = $52. The position becomes profitable if the price moves beyond these points at expiration.

Why Use an Inverse Iron Butterfly?

• Betting on High Volatility/Large Price Swings: This strategy is employed when an investor anticipates a significant price movement in the underlying asset, but is uncertain about the direction. It’s a non-directional strategy.
• Lower Capital Requirement Compared to Buying Straddles/Strangles: While also betting on volatility, an inverse iron butterfly typically has a lower initial cost (maximum risk) than buying a straddle (at-the-money call and put) or a strangle (out-of-the-money call and put).
• Defined Risk: The maximum potential loss is limited to the initial net debit paid.

Key Considerations:

• Probability of Profit: While the potential profit can be substantial if a large move occurs, the probability of such a significant move happening precisely by the expiration date can be lower than strategies with a wider profit range.
• Time Decay (Theta): Time decay generally works against an inverse iron butterfly. As the expiration date approaches, the value of the purchased out-of-the-money options will decline if the price hasn’t moved significantly. This erosion needs to be overcome by substantial price movement.
• Volatility (Vega): An increase in implied volatility after the spread is established can be beneficial, as it increases the value of the purchased out-of-the-money options more than it increases the value of the sold in-the-money options. Conversely, a decrease in implied volatility can be detrimental.
• Early Assignment: There is a risk of early assignment on the short put if the price falls significantly below its strike and on the short call if the price rises significantly above its strike, especially close to expiration or if there are dividends involved.

Managing an Inverse Iron Butterfly:

• Monitoring Price Movement: Closely tracking the underlying asset’s price is crucial. If a significant move occurs, you might consider closing the position to lock in profits.
• Rolling the Spread: If the price approaches one of the outer strikes but hasn’t reached it as expiration nears, you might consider “rolling” the spread by closing the existing positions and opening new ones with different strike prices or expiration dates.
• Adjusting the Strikes: Depending on your outlook, you might adjust the strike prices of the spread if there’s significant time remaining.

In Conclusion:

The inverse iron butterfly is a sophisticated options strategy designed for investors who anticipate a substantial price swing in the underlying asset but are directionally neutral. It offers a defined risk and the potential for significant profit if the price moves beyond the breakeven points by expiration. However, it suffers from time decay and requires significant price movement to be profitable. Careful consideration of volatility, time decay, and the likelihood of a large price change is essential when deploying this strategy.