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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. 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? Want to follow us and see how we trade the butterfly spreads options strategies and other strategies? Start Your Free Trial
This article describes the different variations of the butterfly spread. Long Butterfly Spread This is a limited profit, limited risk options strategy. There are 3 strikes involved in a butterfly spread and it can be constructed using calls or puts. It is entered when the trader believes that the underlying will not move much by expiration. Construction: Buy 1 ITM Call Sell 2 ATM Calls Buy 1 OTM Call OR Buy 1 ITM Put Sell 2 ATM Puts Buy 1 OTM Put P/L chart: There is some confusion regarding terminology, but most sources and brokers agree that "Buy a butterfly" or Long Butterfly means selling the body strikes and buying the wings. Here is a screenshot from Interactive Brokers: Please note that Butterfly spread is purchased for a debit. In order to make a profit, you would aim to sell it for more than you paid for it (exactly like a stock). There is no margin requirement to buy a butterfly, except for the debit paid. Maximum profit for the long butterfly spread is achieved when the underlying price is exactly at the short strikes at expiration. Long Iron Butterfly Spread The same trade can be constructed using combination of calls and puts. Construction: Buy 1 OTM Put Sell 1 ATM Put Sell 1 ATM Call Buy 1 OTM Call P/L chart is identical to the long butterfly spread: Please note that Iron Butterfly spread is purchased for a credit. In order to make a profit, you would aim to buy it back for less debit than the credit you got (exactly like a short stock). There is margin requirement equal to the distance between the short and the long strikes. Buying Iron Butterfly is basically selling ATM straddle and hedging it with OTM strangle. Maximum profit for the long butterfly spread is achieved when the underlying price is exactly at the short strikes at expiration. Example: With TLT trading around $112, we could enter the following butterfly, using calls only: Buy 1 December 21 107 Put Sell 2 December 21 112 Put Buy 1 December 21 117 Put This is a $5 wide butterfly, and the debit would be around $2.15, The maximum price at expiration is $5, so the profit potential is $2.85 or 132%: Same trade could be constructed as an Iron Butterfly, using combination of puts and calls: Buy 1 December 21 107 Put Sell 1 December 21 112 Put Sell 1 December 21 112 Call Buy 1 December 21 117 Call This is a $5 wide butterfly, and the credit would be around $2.85. The margin requirement is 5.00-2.85=2.15, exactly the same as the debit of the put butterfly: As you can see, the P/L chart and the profit potential of the butterfly and iron butterfly are very similar when same strikes are used. Short or Reverse Butterfly Spread This is a limited profit, limited risk options strategy. There are 3 strike prices involved in a butterfly spread and it can be constructed using calls or puts. It is entered when the trader believes that the underlying will move by expiration. This is basically an opposite trade to a long butterfly Construction: Sell 1 ITM Call Buy 2 ATM Calls Sell 1 OTM Call OR Sell 1 ITM Put Buy 2 ATM Puts Sell 1 OTM Put P/L chart: As we can see, the underlying has to move in order for the trade to make a profit. Maximum profit is achieved when the underlying is above the upper sold strike or below the low sold strike. The trade is executed for a credit. Once again, to avoid any confusion, here is a screenshot from Interactive Brokers: Short or Reverse Iron Butterfly Spread The same trade can be executed using a combination of puts and calls. Construction: Sell 1 OTM Put Buy 1 ATM Put Buy 1 ATM Call Sell 1 OTM Call P/L chart: The trade is executed for a debit. Selling Iron Butterfly is basically buying ATM straddle and hedging it with OTM strangle. Frequently Asked Questions How the long butterfly spread 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. What is the risk? The maximum theoretical risk of the long 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. Calls vs. puts In general, there should not be a significant difference between calendar spread using calls or puts. The P/L graph is usually very similar. When opening a delta negative fly, I tend to open it with puts. The reason is that OTM options tend to be slightly more liquid, and there is no assignment risk. Can I be assigned on my short options? If your short options become deep ITM, you can be assigned. Assignment risk becomes real only if there is very little time value left on the short options. 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. Usually 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. However, in some cases we will structure the trade slightly directional if we have a strong bias about the underlying. Summary The butterfly spread has few variations, but they all have few things in common: Three equidistant strikes involved. Same expiration. Limited profit, limited loss. The following table summarizes the most important features of the different variations of the Butterfly Spread strategy. If you want to learn more how to use the butterfly spread and other profitable strategies and increase your odds: Start Your Free Trial Related articles: 4 Low Risk Butterfly Trades For Any Market Environment Using Directional Butterfly Spread
I've traded a wide range of options strategies, but, for a number of reasons, the Butterfly is my preferred trade. The Butterfly option spread is possibly one of the least understood and least utilized options income strategies. Butterflies can be used to construct high probability positions with a profit range similar to and potentially larger than an Iron Condor with less risk. Alternatively, a short dated Butterfly option can provide a great risk/reward ratio when traded slightly out of the money. Perhaps my favorite characteristic of the Butterfly is that the position can make money prior to expiration even if price trades outside of the expiration break even points. In this post we'll take a look at four different Butterflies with very different trading characteristics. 1. At The Money (ATM) Butterfly The ATM Butterfly option is the common Butterfly spread that most options traders think about. The position is placed at the money with anywhere from 7 to 50 days to expiration depending on your strategy. The ATM Butterfly is a short delta trade and can be managed by rolling the initial position up or down or adding additional Butterflies when price trades outside of the expiration break even points. The ATM Butterfly is what most traders think of when they think of the Butterfly. The Butterfly pictured below is an an ATM Iron Butterfly in the Russell 200 (RUT) with 50 point wings and slightly under 30 days to expiration. The biggest challenge with the position is that it leans short delta and will take heat if the market rallies immediately after the trade is entered. 2. Directional Butterfly The Directional Butterfly is a balanced butterfly option spread that is positioned slightly out of the money and works like a lottery ticket. Essentially you position the Butterfly above or below the market and want price to trade towards the short strike. Directional Butterflies can be purchased cheaply, which makes the risk/reward ratio very favorable. In the image below, the Russell 2000 (RUT) closed around 1130 and the image shows the 1130/1150/1170 Call Butterfly with around 30 days to expiration. The Butterfly cost is $190 with a maximum payout of around $1,800. However, risk reward isn't even the best part of the trade. One of the great characteristics of the Directional Butterfly is that the profit/loss line will rise outside of the body of the Butterfly prior to expiration. What that means is that, prior to expiration, the range of potential profit is wider than the expiration break even lines would suggest. In the image below the T+Zero line has been advanced two weeks so we're really looking at the T+14 line. What's important to point out is that the range of profit at T+14 is from 1080 to 1175, which is almost 100 points (around an 8% range) and significantly wider than the body of the Butterfly would suggest. 3. Broken Wing Butterfly (BWB) The BWB is positioned slightly away from the money with unbalanced wings. The trade is usually initiated for a credit and has trading characteristics similar to an out of the money vertical spread. Since Butterflies are made up of two vertical spreads, that doesn't come as a surprise. The broken wing Butterfly pictured below is the RUT 1190/1200/1220 Call Butterfly with 28 DTE that could have been opened for a credit of around .80. At the time of writing, the short strikes at 1200 were around 15 delta. The position is short delta and benefits directionally if price falls, but the T+Zero line will rise up near the body of the Butterfly as the trade approaches expiration. 4. Consistent Income Butterfly (CIB) The Consistent Income Butterfly is my primary trade. The CIB is the combines a Butterfly that is positioned slightly below the money with a long call. The position is constructed with 50 point wings in the Russell 2000 (RUT) and uses a ratio of one Butterfly to one IWM call. On the upside, the position is adjusted by adding up to two additional Butterflies and calls and on the downside the trade is simply rolled down. The philosophy behind the CIB is to keep trade size small on the downside when we expect increased volatility in the markets. On the upside, we add to the position and wait for the bullish trend to rest or pull back. When the trade is started, the position has a very flat T+zero line with the goal of taking on as little directional risk as possible. The image below shows the October 2015 position that is currently open and discussed every weekend. Notice that there is very little directional risk in the trade and a flat T+Zero line when the trade is entered. Now what? One of the big challenges with trading any options strategy is coming up with a set of rules for the strategy. All of the trade ideas above provide a starting point for designing an income strategy. One of the reasons the Butterfly provides a great starting point for an income strategy is that the positions have much wider break evens than you might expect. This post discusses how a Butterfly can be constructed to have a range of profit almost as wide as a high probability Iron Condor. Even though the positions above seem forgiving, it's essential to have a trading plan before placing any trade. Trading well always means making positive expectancy decisions. This article is presented by Dan, founder of Theta Trend, a site focused on simple, objective options trading with an awareness of trend.