Butterfly Spreads - Spread Your Wings and Profit

Published: 15th February 2010
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Butterfly spreads are possibly one of the most well known and favourite option strategies out there today, mainly because they are often referred to in option trading books. They work best when a stock is identified as trading inside a clearly defined range over a period of time. There have been two prevailing schools of thought on identifying range trading stocks.

1. Locate a stock which has been trading in a range over not less than 3 months, preferably longer. Such a stock is more likely to stay within that range in the forseeable future. In other words, you want to steer clear of trending stocks. But be careful! There is a difference between range trading stocks and those whose price range is consolidating into a triangle pattern (lower highs and higher lows converging). These patterns often precede a substantial breakout and so are more appropriate to straddle trades than butterfly spreads.

2. Find stocks that have recently made a significant move which included a huge volume spike. This usually occurs following news announcements or takeover bids. Following this type of move, the stock will probably settle into a range for a month or two, unless the news that caused the spike to begin with is negated (e.g. a takeover bid is retracted and the price drops to prior levels)

When you have identified such a stock, you're almost ready to implement your butterfly spread. First, you then need to locate support and resistance levels at the extremities of the anticipated trading range, then you should identify option strike prices in relation to those levels. Finally, you would ideally like the stock to be currently trading near the middle of the above mentioned support and resistance levels when you place the trade.

Creating a Butterfly Spread

A butterfly spread is essentially a combination of a vertical debit spread and a credit spread sitting directly on top of each other but with a common mid strike price. So all up, you've got 3 strike prices. The two outer levels are termed the 'wings' while the middle strike price is the 'body' of the butterfly. The idea is that you 'buy to open' one option contract of each wing and 'sell to open' two contracts for the body.

You may construct your butterfly spread with either call or put options but not both. Let's suppose we're working with call options, in which case:

Your two 'sold' positions will be 'at the money' (ATM)

Your upper 'bought' position will be 'out of the money' (OTM)

Your lower 'bought' position will be 'in the money' (ITM)

If you employed put options, your sold positions would remain 'at the money' (ATM) but your upper and lower bought positions, as above, would be reversed.

Using either call options or put options would achieve precisely the same result, so when evaluating which to choose, you should target the one that provides the best return on risk. Ideally, you should go for option contracts with 1-2 months to expiry.

Characteristics of a Butterfly Spread

One of the most appealing characteristics about this option strategy is the potential return on investment. If you are able to find a range of option contracts for three strike prices that minimize your initial cost, you can be looking upwards of 300 percent at expiry if the underlying stock closes at the maximum profit level.

Before you place this kind of trade, you have to do your sums. You must know:

1. Your maximum profit potential

2. Your maximum loss (which is limited to the initial cost) and

3. Your breakeven points

Your maximum profit at expiry will be the difference between the 'wing' strike price and the 'body', minus the cost to enter the setup. So if your 3 strike prices were $5 apart and the whole spread cost you $1 to enter, then your maximum profit would be $5 - $1 = $4 per share per contract, which is 400 percent return on risk. But if your 3 strike prices were $10 apart and the entry cost was $3, then your maximum profit would only be $10 - $3 = $7 which is only 233 percent return on risk.

So analysis of the trade's potential before entry is essential. You need to look for the best potential profit opportunities which means paying attention to your initial cost.

Breakeven points at option expiry are places where, if the stock closes, will make no profit or loss. These points will be one of the two extremities of the spread, minus the initial debit paid.

How Much Collateral Do You Need

To get into any option trading position you must have enough funds in your broker account. You'll need enough to fund the vertical debit spread element of the trade, plus enough again to cover the difference between strike prices for the credit spread component. This means less capital will be available for other trading opportunites. Using the case above where strike prices are $5 apart and assuming 100 shares per option contract, you would need $500 $75 collateral, plus brokerage costs, to do your butterfly spread.

Implementing the Strategy

Most butterfly spread examples you'll read about will give you potential profit levels at expiry date. But you don't have to wait till that time to exit the trade. As the expiry date draws near you should review the probability that you can take profits. As previously mentioned, the maximum profit level is achieved when the stock closes at the middle option strike prices at expiry date. But during the last 3 weeks of the trade, the profit level potential increases exponentially, as your 2 'sold' positions at the 'body' of the butterfly experience the most time decay while your ITM long position still has intrinsic value. As expiry date closes in, you should be aware of where the underlying stock price is in relation to the middle strike price. If it crosses it during that time you may wish to take an early profit. It will not be the maximum profit, but a good one nonetheless - and a smaller profit with certainty is better than waiting another week or two in the hope it will return to this maximum profit level.

Beautiful Flexibility

Let's say you had identified support and resistance levels of a stock's trading range and taken out your butterfly setup using call options. Within a short time, the stock retreats lower to the support level. This will mean that your 2 'sold' ATM positions at the 'body' of the trade are now OTM so you can buy them back for 'peanuts' leaving you with your two long calls - one now 'at the money' and the other way 'out of the money'. If the stock moves back into the trading range again, your long calls will increase in value but now you will have no 'short' calls to offset the gain.

If, on the other hand, after your purchase the stock moves up towards the resistance level, you can remember that the top level of your butterfly is actually a credit spread. This gives you the option of 'rolling up' thus extending the 'body' of the butterfly into an Iron Butterfly with greater profit potential.

Owen has traded options for many years. Visit his popular blog to discover powerful Option Trading Strategies including how to use butterfly spreads to stack the odds for success in your favour.

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