Iron butterfly payoff construction in volatile crude

A large crude swing and expensive options

In the first two weeks of July 2008, a single August crude futures contract was described as swinging by about 10000 dollars several times. Outright long options in that energy market were described as costly because implied volatility, premiums, and bid-ask spreads were elevated. In the terms used here, implied-volatility cost is the component of those prices that, when elevated, can make outright long options expensive to enter.

The four-leg iron butterfly

The butterfly was defined as buying one near-the-money option, selling two out-of-the-money options at the same strike, and buying a further equidistant option, with all legs sharing type and expiration. That same-type, same-expiry layout is the iron butterfly: a near-the-money long, two shorts at one shared out-of-the-money strike, and a further long equally far away.

Debit-spread cost, strike width, and peak

A September crude call construction using 121, 126, and 131 strikes was given a net debit of about 85 cents, or 850 dollars, plus commissions and fees across four round turns. Crude option premium was valued at 10 dollars per penny, so an 85-cent debit equals an 850-dollar cash outlay before transaction costs. That outlay is the debit-spread cost: the net premium paid when the long legs cost more than the short legs collect, and before commissions it is also the stated maximum loss.

The inner short strike sits 5 dollars from each outer long strike. That distance is the strike width, and it sets the uncapped peak of the expiration payoff before the debit is subtracted. With a 5-dollar inner width and an 85-cent debit, peak value at expiration was stated as 4.15, or 4150 dollars before transaction costs, if futures were at 126.

Expiration breakevens and time-value delay

At expiration the example was intrinsically profitable only between 121.85 and 130.15, the two prices obtained by adding or subtracting the 85-cent debit from the outer 121 and 131 strikes. Each of those prices is an expiration breakeven: a futures price at expiry where remaining intrinsic value equals the premium originally paid for the spread. Remaining time value in the short options was identified as the main reason the structure may show little profit until close to expiration. That lag is the time-value delay.