A favorite strategy among professional option traders, the long iron butterfly has the best chances of success in most markets. This strategy sounds quite complicated but it's really very simple once you let it soak in. It's sometimes referred to as the "secret weapon of option traders". 

A long iron butterfly trade makes 3 assumptions:

1. Stocks mostly trade within a range.
2. Option sellers usually make more money than option buyers.
3. Selling naked options is too risky.

If those 3 things are mostly true, then the iron butterfly trade. Suppose ABC stock trading around 50 per share. Maybe it drops to the 42-43 range sometimes and goes as high as 56-57.  So it usually trades between 40-60.  Lots of stocks trade in a range like that.  One thing we could do to play this stock is sell the naked put with a strike of 40. Right?  If the stock remains above 40 on expiration day, the put expires and we keep the premium.

Another thing we could do is sell a naked call. Maybe sell the 60 strike. Then if the stock doesn't go over 60, the option expires worthless and we keep the premium.  

Well, why not do both?  We could sell the put and the option. As long as the stock closes between 40 and 60 then both options expire worthless and we keep all the premium.  That's a naked strangle. 

If we take it one step further we can set up a long iron butterfly and not have the awful risk of having naked options as a liability.

We could sell the 40 put, then buy the 35 put for insurance against a market collapse. Our risk could be no more than 5 points. Essentially we have have sold a bull put spread.  At the same time, we sell the 60 call and buy a 65 call, thus setting up a bear call spread, and again minimizing our risk since we are not now in a naked option position.

Did that soak in?  Let me summarize.... If you think a stock will trade within a range, you can sell out of the money options, both puts and calls, and collect the premiums. But instead of selling them naked, you do it in the form of a spread to eliminate most of the risks. 

If you think a stock will stay around 80, then you sell the 70 put (then buy the 65) and simultaneously sell the 90 call (and buy the 95).  You're selling a spread on each side of the stock price. Even if the stock goes against you, it can't go against you in both directions. This is why professionals love this strategy.  If the stock goes down the put spread may hurt you, but the call spread will be a success. The stock is either down or up. It can't be both.  So even if you take a loss on one side of the trade, the profit from the other side will help offset that.

 

Strategies		Long Iron Butterfly
Component		Sell out of the money bull put spread, sell out of the money bear call spread. Both spreads expiring the same month.
Potential profit		When the stock price is between the short put and the short call.
Maximum loss		When the stock price is below the lower strike of the put spread, or when the stock price is higher than the higher strike price of the call spread. Limited to the point spread of just one of the spreads.
Time value impact		Positive
Break-even		The lower break-even point equals to the short put strike price minus total premium received The upper break-even point equals to the short call strike price minus total premium received
		Compared with Short Strangle, the Long Iron Butterfly does not sell naked options. One sells the strangle, but buys farther out of the money options for protection.

Example: