Using Directional Butterfly Spread

Butterfly Spread Construction

• Buy 1 ITM Call
• Sell 2 ATM Calls
• Buy 1 OTM Call

Same trade can be constructed using puts. 

The maximum gain is realized if the stock is near the sold strikes at expiration. If this happens, the short ATM options and the OTM options will expire worthless but ITM options will have value equal to distance between ITM and ATM options.

Example

With SPX trading around 2170, we entered 2100/2150/2200 put butterfly:

• Buy to open 1 SPX November 11 2016 2100 put
• Sell to open 2 SPX November 11 2016 2150 put
• Buy to open 1 SPX November 11 2016 2200 put

This is a real trade that we executed few days ago. This is how the P/L chart looks like:

As you can see from the chart, even if SPX moves just 1-2% lower, the trade can produce very nice gains.

How the butterfly spread options strategy makes money?  

The first way is the time decay. The idea is that ATM options will lose value faster than the ITM and OTM options.

The second way a Butterfly Trade makes money is with an decrease in volatility. This is why I prefer to start the trade slightly delta negative (usually around 15-20 points on SPX). This was if the stock moves higher, decrease in IV should reduce the loss.

In many cases, if we start the trade when IV is high and SPX is moving higher, we can still close the trade for a small gain due to volatility collapse.

What is the risk?

The maximum theoretical risk of the butterfly is the debit paid. If we hold the trade till the expiration and the stock trades outside of the P/L zone, the trade will lose 100%. As a general rule of thumb, the average loser size should not exceed the average winner size. 

Typically we would enter those trades 5-6 weeks to expiration and holds for 2-3 weeks. The trade is short gamma, and the gamma risk is the main risk of this strategy.

Can I be assigned on my short options?

If your short options become ITM, you can be assigned. There is no assignment risk on indexes like SPX or RUT, but stocks like SPY or IWM (or individual stocks) do have assignment risk.

Assignment by itself is not a bad thing - unless it causes a margin call and forced liquidation. Worst case scenario, the broker will liquidate the shares in pre-market, the stock will rise between the liquidation and the open and the puts will be worth less. Otherwise, you are 100% covered - each dollar you lose in the stock you gain in the options.

Directional or non-directional?

At SteadyOptions, we trade non-directional trading. So in most cases, we will want to be as delta neutral as possible. 

Generally speaking, I would select the ATM strike slightly below the current price. The reason: typically, when stocks move up, IV goes down. Since fly is vega negative, it will benefit the trade and reduce the gamma loss. However, if we begin slightly delta negative, the trade will gain as we move closer to the strike and compensate any vega losses. 

Profit target and stop loss

My profit target on the butterfly trade is around 20-25% and stop loss is around 30-35%. In some rare cases, I might allow for 40-50% loss but we should do everything possible not to allow the loss exceed 50%.

Since we allocate only 10% to our trades, 30% loss means 3% loss on the whole account, which is acceptable to me. If I traded bigger size, I would implement different adjustment or exit strategy to limit the overall loss. This is relatively aggressive trade that aims for higher gains but also allows higher losses.

Summary

This is a trade I like to place on a regular basis every month. When placed 15-20 points above the current price, it can provide excellent returns if the market moves lower. The returns are usually in the 25-30% range. If the market moves sharply higher, it can be usually closed for breakeven or a small loss.

Related Articles

• Butterfly Spread Strategy - The Basics
• 4 Low Risk Butterfly Trades For Any Market Environment
• The Options Greeks: Is It Greek To You?
• Can Options Assignment Cause Margin Call?

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