The Reverse Iron Butterfly: Profiting from a Breakout

# The Reverse Iron Butterfly: Profiting from a Breakout

The Reverse Iron Butterfly is a strategy designed to profit from a significant price movement in either direction. It is the opposite of a standard Iron Butterfly, which is a neutral strategy that profits from a range-bound market. This article will cover the construction, management, and ideal market conditions for this breakout strategy.

The Logic of the Reverse Iron Butterfly

The Reverse Iron Butterfly is a debit spread, meaning that it costs money to put on. However, it has the potential for a large profit if the underlying asset makes a big move. The strategy is constructed by buying an at-the-money (ATM) straddle and selling an out-of-the-money (OTM) strangle. This creates a "V" shaped profit/loss profile with a small loss zone in the middle and unlimited profit potential on the upside and downside.

Constructing the Reverse Iron Butterfly

To construct a Reverse Iron Butterfly, you would typically do the following:

• Buy one ATM call
• Buy one ATM put
• Sell one OTM call
• Sell one OTM put

The OTM options are the "wings" of the butterfly and are equidistant from the ATM strike.

Managing the Reverse Iron Butterfly

Managing a Reverse Iron Butterfly is relatively simple. If the underlying asset makes a big move in either direction, the position will become profitable. The trader can then take profits by closing the position. If the underlying asset does not make a big move, the position will expire worthless and the trader will lose the debit paid to put on the trade.

Identifying Breakout Opportunities with Ichimoku

The Ichimoku Cloud can be used to identify potential breakout opportunities. When the Kumo, or cloud, is narrowing, it is a sign that the market is consolidating and a breakout is imminent. When the price breaks out of the Kumo, it is a sign that a new trend is beginning. This is an ideal time to enter a Reverse Iron Butterfly.

Profit/Loss Formula

The profit/loss of a Reverse Iron Butterfly can be calculated using the following formula:

P/L = (Max(Underlying Price - Strike Call, 0) + Max(Strike Put - Underlying Price, 0) - (Max(Underlying Price - Strike Call Wing, 0) + Max(Strike Put Wing - Underlying Price, 0))) - Net Debit

P/L = (Max(Underlying Price - Strike Call, 0) + Max(Strike Put - Underlying Price, 0) - (Max(Underlying Price - Strike Call Wing, 0) + Max(Strike Put Wing - Underlying Price, 0))) - Net Debit

Performance in a Breakout

The following table shows the performance of a Reverse Iron Butterfly during a market breakout:

Conclusion

The Reverse Iron Butterfly is a effective tool for traders who believe a big move is imminent. By using the Ichimoku Cloud to identify potential breakout opportunities, traders can increase their chances of success with this strategy. However, it is important to remember that this is a debit spread and the trader will lose the entire premium paid if the underlying asset does not make a big move._