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Neutral Option Strategies » Butterfly.
The long butterfly spread is a three-leg strategy that is appropriate for a neutral forecast - when you expect the underlying stock price (or index level) to change very little over the life of the options.
A butterfly can be implemented using either call or put options. For simplicity, the following explanation discusses the strategy using call options.
A long call butterfly spread consists of three legs with a total of four options: long one call with a lower strike, short two calls with a middle strike and long one call of a higher strike. All the calls have the same expiration, and the middle strike is halfway between the lower and the higher strikes. The position is considered "long" because it requires a net cash outlay to initiate.
When a butterfly spread is implemented properly, the potential gain is higher than the potential loss, but both the potential gain and loss will be limited.
The total cost of a long butterfly spread is calculated by multiplying the net debit (cost) of the strategy by the number of shares each contract represents. A butterfly will break-even at expiration if the price of the underlying is equal to one of two values. The first break-even value is calculated by adding the net debit to the lowest strike price. The second break-even value is calculated by subtracting the net debit from the highest strike price. The maximum profit potential of a long butterfly is calculated by subtracting the net debit from the difference between the middle and lower strike prices. The maximum risk is limited to the net debit paid for the position.
Butterfly spreads achieve their maxim profit potential at expiration if the price of the underlying is equal to the middle strike price. The maximum loss is realized when the price of the underlying is below the lowest strike or above the highest strike at expiration.
As with all advanced option strategies, butterfly spreads can be broken down into less complex components. The long call butterfly spread has two parts, a bull call spread and a bear call spread. The following example, which uses options on the Dow Jones Industrial Average (DJX), illustrates this point.
n this example the total cost of the butterfly is the net debit ($.50) x the number of shares per contract (100). This equals $50, not including commissions. Please note that this is a three-legged trade, and there will be a commission charged for each leg of the trade.
An expiration profit and loss graph for this strategy is displayed below.
*The profit/loss above does not factor in commissions, interest, tax, or margin considerations.
This profit and loss graph allows us to easily see the break-even points, maximum profit and loss potential at expiration in dollar terms. The calculations are presented below.
The two break-even points occur when the underlying equals 72.50 and 77.50. On the graph these two points turn out to be where the profit and loss line crosses the x-axis.
First Break-even Point = Lowest Strike (72) + Net Debit (.50) = 72.50.
Second Break-even Point = Highest Strike (78) - Net Debit (.50) = 77.50.
The maximum profit can only be reached if the DJX is equal to the middle strike (75) on expiration. If the underlying equals 75 on expiration, the profit will be $250 less the commissions paid.
Maximum Profit = Middle Strike (75) - Lower Strike (72) - Net Debit (.50) = 2.50.
$2.50 x Number of Shares per Contract (100) = $250 less commissions.
The maximum loss, in this example, results if the DJX is below the lower strike (72) or above the higher strike (78) on expiration. If the underlying is less than 72 or greater than 78 the loss will be $50 plus the commissions paid.
Maximum Loss = Net Debit (.50)
$.50 x Number of Shares per Contract (100) = $50 plus commissions.
By looking at the components of the total position, it is easy to see the two spreads that make up the butterfly.
Bull call spread: Long 1 of the November 72 calls & Short one of the November 75 calls.
Bear call spread: Short one of the November 75 calls & Long 1 on the November 78 calls.
A long butterfly spread is used by investors who forecast a narrow trading range for the underlying security, and who are not comfortable with the unlimited risk that is involved with being short a straddle. The long butterfly is a strategy that takes advantage of the time premium erosion of an option contract, but still allows the investor to have a limited and known risk.
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Butterfly Spread.
The butterfly spread is a neutral strategy that is a combination of a bull spread and a bear spread. It is a limited profit, limited risk options strategy. There are 3 striking prices involved in a butterfly spread and it can be constructed using calls or puts.
Sell 2 ATM Calls.
Long Call Butterfly.
Long butterfly spreads are entered when the investor thinks that the underlying stock will not rise or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower striking in-the-money call, writing two at-the-money calls and buying another higher striking out-of-the-money call. A resulting net debit is taken to enter the trade.
Limited Profit.
Maximum profit for the long butterfly spread is attained when the underlying stock price remains unchanged at expiration. At this price, only the lower striking call expires in the money.
The formula for calculating maximum profit is given below:
Max Profit = Strike Price of Short Call - Strike Price of Lower Strike Long Call - Net Premium Paid - Commissions Paid Max Profit Achieved When Price of Underlying = Strike Price of Short Calls.
Limited Risk.
Maximum loss for the long butterfly spread is limited to the initial debit taken to enter the trade plus commissions.
The formula for calculating maximum loss is given below:
Max Loss = Net Premium Paid + Commissions Paid Max Loss Occurs When Price of Underlying = Strike Price of Higher Strike Long Call.
Breakeven Point(s)
There are 2 break-even points for the butterfly spread position. The breakeven points can be calculated using the following formulae.
Upper Breakeven Point = Strike Price of Higher Strike Long Call - Net Premium Paid Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid.
Suppose XYZ stock is trading at $40 in June. An options trader executes a long call butterfly by purchasing a JUL 30 call for $1100, writing two JUL 40 calls for $400 each and purchasing another JUL 50 call for $100. The net debit taken to enter the position is $400, which is also his maximum possible loss.
On expiration in July, XYZ stock is still trading at $40. The JUL 40 calls and the JUL 50 call expire worthless while the JUL 30 call still has an intrinsic value of $1000. Subtracting the initial debit of $400, the resulting profit is $600, which is also the maximum profit attainable.
Maximum loss results when the stock is trading below $30 or above $50. At $30, all the options expires worthless. Above $50, any "profit" from the two long calls will be neutralised by the "loss" from the two short calls. In both situations, the butterfly trader suffers maximum loss which is the initial debit taken to enter the trade.
Note: While we have covered the use of this strategy with reference to stock options, the butterfly spread is equally applicable using ETF options, index options as well as options on futures.
Commissions.
Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the butterfly spread as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.
If you make multi-legged options trades frequently, you should check out the brokerage firm OptionsHouse where they charge a low fee of only $0.15 per contract (+$4.95 per trade).
Similar Strategies.
The following strategies are similar to the butterfly spread in that they are also low volatility strategies that have limited profit potential and limited risk.
Short Butterfly.
The converse strategy to the long butterfly is the short butterfly. Short butterfly spreads are used when high volatility is expected to push the stock price in either direction.
Long Put Butterfly.
The long butterfly trading strategy can also be created using puts instead of calls and is known as a long put butterfly.
Wingspreads.
The butterfly spread belongs to a family of spreads called wingspreads whose members are named after a myriad of flying creatures.
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How to trade a Butterfly.
Butterfly Strategy Description:
A Butterfly works by Selling 2 contracts on the Strike near the current Market price with the current Expiration Date, and then Buying 1 contract on either side, approximately 1 Standard Deviation away with the same Expiration Date. The 'wings', the positions we buy, must be the same distance away from the Short strike, otherwise it will create an uneven Butterfly with a Maintenance requirement.
We can do Butterfly trades on PUTs and CALLs, and we generally only stay in the trade for 17 to 20 days.
A Butterfly Spread is a DEBIT spread: we pay to enter the trade and there is no maintenance requirement. The value of our Long positions will always cover any potential loss from the Short positions. Therefore, the maximum amount of loss possible on a Butterfly trade is the amount we pay for the trade.
Let's take our fictitious company AcmePlus as an example. AcmePlus stock is currently trading at $100 per share. We can Buy 1 Contract of the JUNE 95 CALL for $5.50 per share, and we Sell 2 Contracts of the JUNE 100 CALL for $2.25 per share, and we can Buy 1 Contract of the JUNE 105 CALL for $0.40 per share. [Remember that Options Contracts represent 100 shares of stock.]
=> When we Buy 1 CONTRACT of the JUNE 95 CALL Strike for $5.50, we will have to pay $550 immediately to cover that purchase. (We bought 1 CONTRACT of the JUNE 95 CALL for $5.50 PER SHARE, and there are 100 shares in 1 CONTRACT = $550.)
=> When we Sell 2 CONTRACTS of the JUNE 100 CALL Strike for $2.25, we will get paid $450 immediately into our Brokerage account. (We sold 2 CONTRACTS of the JUNE 100 CALL for $2.25 PER SHARE [$225 * 2 = $450].)
=> When we Buy 1 CONTRACT of the JUNE 105 CALL Strike for $0.40, we will have to pay $40 immediately to cover that purchase. (We bought 1 CONTRACT of the JUNE 105 CALL for $0.40 PER SHARE, and there are 100 shares in 1 CONTRACT = $40.)
=> Our Gross Cost = $140 ($550 + -450 + 40)
=> The maximum possible gross loss is $140. This is what would happen if the Market price of AcmePlus was above or below the max loss point at the JUNE Expiration: the Expiration of our Short Strike.
We can see below on the graph of a Butterfly trade the location of both the max loss points and the break-even points.
The maximum profit on a Butterfly Spread is at our Short Strike—in our example it is the 100 Strike. In many Butterfly Spreads, the maximum profit at expiration can be over 250%, but don't get too excited just yet. We generally only hold Butterfly trades for 17 to 20 days, and then we exit. If all goes well, we can expect to exit with a nice profit of 10% to 20%.
It is possible to hold a Butterfly spread on a Cash Settled Index until Expiration.
When we trade Options, we don't have to go through the process of buying and selling the individual Options of our Butterfly or other spread trades. We can make a "Spread" order, where we specify what Options we want to Buy and Sell, and we can say what NET amount we want to get. (See the explanation in the Condor and Calendar sections.)
On a Butterfly, we can generally get better pricing by splitting the trade up into 2 Vertical Spreads:
# 1: Vertical Spread with: 1 Long and 1 Short.
# 2: Vertical Spread with: 1 Short and 1 Long.
COST & MARGIN REQUIREMENTS:
=> Debit Spread. We pay to enter the trade.
=> Maintenance Requirement: There is no maintenance. Our maximum loss is the amount we paid for the Butterfly spread.
We profit on a Butterfly trade through the reduction of Time Premium of our Short positions during the 17 to 20 days that we are in the position. Since one of our Long positions is In The Money, almost all of the cost of that Option will be Intrinsic value. However, the amount that the position is In The Money, the value of our Short Positions, will be almost all Time Value. As we get closer to Expiration, we will be able to sell our Long positions for about what we paid for them. However, it will cost us less to buy back our Short positions, and we end up with a profit. In essence, we buy the Butterfly at a low price, and then sell to close it later at a higher price.
HOW WE CAN HAVE A LOSS:
=> When the underlying has unusual price movements in one direction that force us to remove our positions early.
=> When the Implied Volatility (IV) goes up / trends up.
Butterfly Trades have probabilities of success around 50%.
It is possible to combine multiple Butterfly positions to widen the area of profitability. It is also possible to remove and replace Butterfly's according to Market movements.
The current price of AcmePlus stock is $100 per share.
Example: CALL Butterfly.
We BUY 1 Contract | ACMEPLUS | JUNE | 95 | CALL | $5.50 per share.
We SELL 2 Contracts | ACMEPLUS | JUNE | 100 | CALL | $2.25 per share (-225 * 2 = -450)
We BUY 1 Contract | ACMEPLUS | JUNE | 105 | CALL | $0.40 per share.
GROSS DEBIT = $140 ($550 + -450 + 40)
MAINTENANCE = zero (There is no maintenance on Butterflys; the maximum loss is what you paid for the trade.)
Butterfly Trade Finder Rules:
Butterfly Trades place the Short Strikes near the current price of the underlying, and the Long Strikes are equally distant at approximately 1 Standard Deviation for 17 Days away from the Short Strikes. It is held for 17 to 20 days. We can do Butterfly trades on PUTs and CALLs.
The Uncle Bob's Money Trade Checklist and Trade Finder automatically check all the relevant factors.
=> Time to Enter Trade: 35 days until 25 days prior to expiration.
=> Preferred Time to Enter Trade: 30 days prior to expiration.
=> Minimum Time Premium: N/A.
=> Earnings and News: On Stocks: no news, no Earnings, no mergers, no splits, no takeovers, etc. Any one of those items can cause the price of the Underlying to jump.
=> Time In Trade: 17 to 20 days. Butterflys can be held until Expiration.
=> Maximum IV: Less than 35.
=> IV Range: Any IV value is OK. High IV is OK if you think it will go down.
=> IV Channeling: Channeling for at least 45 days.
=> IV Trend UP: Fair to Bad.
=> IV Trend DOWN: Good.
=> IV Skew Range: N/A.
=> Minimum Underlying Price: $75. If the price of the underlying is too low, the price of the Options will be too low, and there won't be enough Time Premium decay to create a healthy profit.
=> Strike Pricing: Long positions approximately 1 Standard Deviation based on 17 days Expiration. Evaluate the price of PUTs vs. CALLs, choose whichever has the best pricing.
=> Minimum Premium: N/A.
=> Price Movements in Last Week: +/- 5%
=> Price Movements in Last Month: +/- 10%
=> Price Movements in Last 3 Months: +/- 15%
=> Delta Neutral: For Advanced Traders, it is recommended to be Delta Neutral when placing the trade. Add extra Long positions to balance the Delta, but be careful not to reduce the Theta by more than half.
Butterfly Price Negotiation:
=> Beginning traders can put in all 3 legs of the Butterfly as one trade to start. It is best to trade one Spread at a time: Trade the 2 vertical Spreads separately. (LONG and SHORT as one Spread, and the SHORT and LONG as the other Spread)
=> Determine the highest price to pay before starting to trade.
=> Start at the Mid Price and wait a few minutes. (Be more patient if you have one large order with all 3 legs.)
=> Increase price by the smallest amount possible ($0.01, $0.05, etc.), and wait before changing the price again. Never exceed the highest price limit.
Butterfly Trade Monitor Rules:
The Uncle Bob's Money Trade Monitor automatically shows the profit level for each strategy and checks the relevant factors.
=> If the underlying reaches the Expiration break-even point, exit the trade.
=> If the IV Trend goes UP, exit the trade.
=> If the price movement of the underlying exceeds the Trade Finder values, exit the trade.
=> If the Time in Trade exceeds 20 days, the position should be monitored very closely or exit.
=> Butterfly trades on Cash Settled Indexes can be held until Expiration.
Butterfly Suggested Conditional Orders:
The Uncle Bob's Money Trade Monitor automatically shows the suggested break-even points, which are used for placing Conditional Orders.
The current price of AcmePlus stock is $100 per share.
We BUY 1 Contract | ACMEPLUS | JUNE | 95 | CALL.
We SELL 2 Contracts | ACMEPLUS | JUNE | 100 | CALL.
We BUY 1 Contract | ACMEPLUS | JUNE | 105 | CALL.
break-even up-side: 103.
break-even down-side: 97.
( The break-even points are listed on the Uncle Bob's Money Trade Monitor Page. )
STEP A) Select "Single Order"
=> Select the Butterfly Trade, and create a 'closing order'. (You can manually select the opposite spread to close the position if your Broker doesn't have the 'closing order' possibility.)
=> Time in Force: GTC (Good 'Til Cancelled)
=> Price Rules: Market (We don't want to set a limit price, because we don't know what the pricing will be and we want to close this position if the underlying hits our break-even point.)
=> Submit at Specified Market Condition #1: When the "MARK" of the Underlying is " AT OR ABOVE " price of " 103 " ( Make sure to use the Up-side break-even as listed in the Uncle Bob's Money Trade Monitor for your own trade. )
=> Submit at Specified Market Condition #2: When the "MARK" of the Underlying is " AT OR BELOW " price of " 97 " ( Make sure to use the Down-side break-even as listed in the Uncle Bob's Money Trade Monitor for your own trade. )
Your broker will describe this trade as:
1. Wait until at least the one of the following conditions is satisfied (this order will show a WAIT COND status during waiting):
*) mark price of the security is less or equal to 97.00;
*) mark price of the security is greater or equal to 103.00;
2. Submit the following order: SELL -1 BUTTERFLY ACMEPLUS JUNE 95/100/105 CALL at current market price. The order is valid until it is either filled or cancelled.
STEP C) Confirm that the trade was entered correctly, and submit the trade.
We now have a conditional order that will close our Butterfly trade if the underlying price hits ONE of our break-even points.
NOTE : If we decide to manually exit positions, we must first cancel ALL conditional orders that we placed on those positions.
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Butterfly Spread.
What is a 'Butterfly Spread'
A butterfly spread is a neutral option strategy combining bull and bear spreads. Butterfly spreads use four option contracts with the same expiration but three different strike prices to create a range of prices the strategy can profit from. The trader sells two option contracts at the middle strike price and buys one option contract at a lower strike price and one option contract at a higher strike price. Both puts and calls can be used for a butterfly spread.
BREAKING DOWN 'Butterfly Spread'
Butterfly spreads have limited risk, and the maximum losses that occur are the cost of your original investment. The highest return you can earn occurs when the price of the underlying asset is exactly at the strike price of the middle options. Option trades of this type are structured to have a high chances of earning a profit, albeit a small profit. A long position in a butterfly spread will earn profit if the future volatility of the underlying stock price is lower than the implied volatility. A short position in a butterfly spread will earn a profit when the future volatility of the underlying stock price is higher than the implied volatility.
An Example of a Butterfly Spread.
By selling short two call options at a given strike price, and buying one call option at an upper and one at a lower strike price (often called the wings of the butterfly), an investor is in a position to earn a profit if the underlying asset achieves a certain price point at expiration. A critical step in constructing a proper butterfly spread is that the wings of the butterfly must be equidistant from the middle strike price. Thus, if an investor short sells two options on an underlying asset at a strike price of $60, he must purchase one call option each at the $55 and $65 strike prices.
In this scenario, an investor would make the maximum profit if the underlying asset is priced at $60 at expiration. If the underlying asset is below $55 at expiration, the investor would realize his maximum loss, which would be the net price of buying the two wing call options plus the proceeds of selling the two middle strike options. The same occurs if the underlying asset is priced at $65 or above at expiration.
If the underlying asset is priced between $55 and $65, a loss or profit may occur. The amount of premium paid to enter the position is key. Assume that it costs $2.50 to enter into the position. Based on that, if the underlying asset is priced anywhere below $60 minus $2.50, the position would experience a loss. The same holds true if the underlying asset were priced at $60 plus $2.50 at expiration. In this scenario, the position would profit if the underlying asset is priced anywhere between $57.50 and $62.50 at expiration.
Long Call Butterfly Spread.
There are several different kinds of butterfly spreads. The long butterfly spread is created by buying one in-the-money call option with a low strike price, writing two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. A net debit is created when entering the trade.
Short Call Butterfly Spread.
The short butterfly spread is created by one in-the-money call option with a low strike price, buying two at-the-money call options, and selling an out-of-the-money call option at a higher strike price. A net credit is created when entering the position.
Long Put Butterfly Spread.
The long put butterfly spread is created by buying one put with a lower strike price, selling two at-the-money puts, and buying a put with a higher strike price. A net debit is created when entering the position.
Short Put Butterfly Spread.
The short put butterfly spread is created by writing one out-of-the-money put option with a low strike price, buying two at-the-money puts, and writing an in-the-money put option at a higher strike price.
Iron Butterfly Spread.
The iron butterfly spread is created by buying an out-of-the-money put option with a lower strike price, writing an at-the-money put option with a middle strike price, writing an at-the-money call option with a middle strike price, and buying an out-of-the-money call option with a higher strike price. The result is a trade with a net credit that's better suited for lower volatility scenarios.
Reverse Iron Butterfly Spread.
The reverse iron butterfly spread is created by writing an out-of-the-money put option at a lower strike price, buying an at-the-money put option at a middle strike price, buying an at-the-money call option at a middle strike price, and writing an out-of-the-money call option at a higher strike price. This creates a net debit trade that's better suited for high-volatility scenarios.
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