Butterfly Option Spreads
The butterfly is a neutral position that is a
combination of a bull spread and a bear spread.
Let's look at an example using calls.
IBM price: 60
July 50 Call: $12
July 60 Call $6
July 70 Call $3
Butterfly:
Buy 1 July 50 Call $1,200 Debit
Sell 2 July 60 Call $1,200 Credit
Buy 1 July 70 Call $300 Debit
$300 Debit to place the trade
Our maximum loss is our debit of
$300.
The Maximum profit is the difference between strikes
minus the debit (10-3=7)
So our Max gain is $700.
Results of butterfly spread at expiration
| Price at Expiration |
July 50 Profit |
July 60 Profit |
July 70 profit |
Total Profit |
| 40 |
-1200 |
1200 |
-300 |
-300 |
| 50 |
-1200 |
1200 |
-300 |
-300 |
| 53 |
-900 |
1200 |
-300 |
0 |
| 56 |
-600 |
1200 |
-300 |
300 |
| 60 |
-200 |
1200 |
-300 |
700 |
| 64 |
200 |
400 |
-300 |
300 |
| 67 |
500 |
-200 |
-300 |
0 |
| 70 |
800 |
-800 |
-300 |
-300 |
| 80 |
1800 |
-2800 |
700 |
-300 |
As you can see our breakeven points
are 53 and 67. As long as IBM stays between those
strikes we make money.
If you sign up for my FREE
Option Selling Course I will show you some examples
of Butterflies and Iron Condor trades I did with
real money and how I adjusted them to stay out
of trouble. To sign up just fill out your name
and email in the sign up form at the Top, Right
of this page.
Why Use the Butterfly
Options Trade?
Butterflies are used in a few different
ways. The most popular is on an underlying that
is not moving very much and in which the trader
feels that volatility will fall. As volatility
falls, the biggest impact should be to the sold
options since they are At the Money. This will
result in them losing value and thus a profit.
Even if volatility does not fall
rapidly, as the days go by the trade will make
money through time decay. Since this is a theta
positive trade, everyday that you are in the trade,
the options lose value and the trade makes money.
So normally a trader wants the underlying
stock, index, ETF, whatever to stay within the
breakevens and as close to the sold strike as
possible. The closer to the sold strike at expiration,
the more money the trade makes.
Butterflies are also used in speculation.
Out of the money butterflies are very cheap. If
a trader thinks the stock is going up, he can
do an bullish out of the money butterfly at a
higher strike. If the stock makes it into the
butterfly breakeven area, the trader can make
several hundred percent. This works on the down
side as well.
And that is how you can use the
butterfly as a cheap hedge. Let's say you own
a lot of IBM stock and you think that IBM might
go down on a bad earnings announcement. You can
buy some bearish out of the money butterflies
that will make a lot of money if IBM does drop.
Here is a link to a post on my blog
that shows a butterfly that I did in my personal
account along with a picture of the profit and
loss diagram. Notice the triangle shape of the
graph.
Butterfly
Option Spread Trade in MCD
I trade Butterflies every month.
Become a member today to get access to my site
and my current trades. You can also see my past
trades and how I adjusted them when I had to.
Find out more about becoming a member.
The Iron Butterfly
Until now we have been talking about a regular
butterfly. Now let's talk about the Iron Butterfly.
What's the difference? A few strikes.
With a regular butterfly spread trade, you sell
the At the Money Strike and the trade uses all
put options or call options.
When doing an iron butterfly trade, you use both
put options and call options, and the sold strikes
are not At the Money but a strike or more out
of the money. Here's an example:
IBM is at 100. With a regular butterfly trade,
we buy 2 of the 95 calls, sell 4 of the 100 calls,
and buy 2 of the 105 calls. Instead of calls you
can use puts, they are pretty much interchangeable.
With an iron butterfly you sell 2 of 105 calls,
and buy 2 of the 110 calls. You also sell 2 of
the 95 Puts and buy 2 of the 90 puts.
This makes your breakeven "tent" a
bit wider and you can let all the options expire
if IBM is in between your sold strikes of 95 and
105 at breakeven. An iron butterfly is a credit
trade, while the regular butterfly trade results
in a debit. You have to exit the regular butterfly
and cannot let is expire.
If you are familiar with iron condors, you will
see that an iron butterfly is an iron condor,
except the strikes are close to the money. You
can also do an iron butterfly where you are at
the money instead of out of the money.
I trade Butterflies every month.
Become a member today to get access to my site
and my current trades. You can also see my past
trades and how I adjusted them when I had to.
Find out more about becoming a member.
The Broken Wing Butterfly
The Broken Wing Butterfly is another variation
of the classic butterfly options trade. You create
a broken wing by changing the wingspan of the
trade.
So if a classic butterfly is Buy 5 of the 100,
Sell 10 of the 150 and Buy 5 of the 200 calls,
you can see that the distance between the edge
and the center is 50 points. With a broken wing
butterfly you can have one of the legs be shorter
than the other. Example: Buy 5 of the 100, Sell
10 of the 150, Buy 5 of the 160 calls.
By changing the wingspan, you can make the broken
wing butterfly a directional trade either bullish
or bearish. The trade will still make money if
the stock does not move much, but you can set
the trade up in a way that you can only lose in
one direction.
It's pretty much like a credit spread.
So why do a broken wing butterfly instead of
a credit spread? Because it is easier to adjust.
If the stock moves heavily against you, you can
still adjust the trade to make money on it. With
a credit spread, your adjustment options are limited.
But there is a problem. In 2010, the brokers
and the governmental body that regulates options
decided to change the margin requirements on broken
wings. Now you are charged margin on both sides
of the trade. In many cases, you can only lose
money on one side of the butterfly, so you should
only be charged margin on one side. But they are
now charging margin on both sides. You can still
do the trade, but your ROI is half of what it
should be. Unless you have a portfolio margin
account. But that is a different discussion.
Trading Butterfly Option
This has been a shot introduction to different
butterflies. In order to really learn how to trade
the butterfly you have to practice. As part of
our advisory, we trade iron condors, butterflies,
credit spreads, calendars, and double diagonals.
Here is a link to a blog post that discusses
when to trade a butterfly instead of a calendar:
Butterfly
or Calendar?
Butterfly Option Trade Adjustments
For a classic butterfly, the simplest adjustment
is just to add a second butterfly when the stock
hits a breakeven point. Let's look at the example
at the top of this page.
IBM is at 60
Butterfly:
Buy 1 July 50 Call Option
Sell 2 July 60 Call Options
Buy 1 July 70 Call Option
Breakevens are at 53 and 67.
Let's say you put this trade in and IBM advances
to 67. You just hit your expiration day breakeven.
You adjust by adding a second butterfly at the
strike closest to the money for the same expiration:
65.
Buy 1 July 55 Call Option
Sell 2 July 65 Call Options
Buy 1 July 75 Call Option
This expands your breakeven and lets you stay
in the trade. But this also doubles the amount
of money in the trade (and at risk) as well as
lowering your potential ROI%.
If IBM keeps moving up and hits your upside breakeven
again, you can exit the first butterfly and stay
in the trade.
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