Now begins our step-by-step guide to trading the Long Butterfly Spread. There are four major steps (if I didn't miss any) and many mini-steps for each. Keep in mind that although its called a Long Butterfly, the active strike is the middle one, which is always short. The whole spread, is treated at each step; we do not split the Butterfly up.
After you have selected strategy and strikes, you may prepare the opening order in your trading platform. The steps would be the same, no matter which underlying stock or index you use.
Our example here will be a SPY 250 Call Butterfly with body at 250, and wings at 249 and 251.
Here are the steps, represented as blue circles on the screenshot and numbered and described below:
OPENING A LONG BUTTERFLY SPREAD
1. Choose the Trade tab and type in the underlying stock such as SPY.
2. Select Spread: Butterfly.
3. Choose expiration date in the option chain.
4. Locate the center strike (250).
5. Choose either Puts or Calls, and compare “bid” and “ask” spread.
6. Click the “Ask” to buy the spread. You should end up with a green trade ticket like this:
7. Inspect trade ticket.
8. Adjust strikes, quantity, price and order type (here GTC).
9. Click “Confirm and Send”.
10. Review the “Order Confirmation Dialogue” and click “Send”.
Now two final steps:
11. Review “Working Orders” and check on the “mark”.
12. Use the “Cancel and Replace” function to adjust your price, if necessary.
Once the position has been filled, it will disappear from Monitor/Working Orders and suddenly appear in Monitor/Filled Orders.
CLOSING A LONG BUTTERFLY SPREAD
13. Once your opening position has been filled, you can place an order to close. Do not place the closing order before that, however, as you will get this notice:
“Entering this order will cancel your open working orders.”
14. In thinkorswim, simply right-click on the 3-legged position and choose “Create Opposite Order”. A red ticket will appear, showing a credit.
15. Adjust the selling price or credit based on expected value at expiration and send the order GTC. The selling price in our GOOGL example would be set for $2.00, or 50% of maximum available credit (MAC).
16. Review the stock chart, Analyze Tab, and Monitor to make sure the closing order is active. Relax. It will fill whenever it fills.
Some important things to keep in mind:
- Most commonly, the Long Butterfly is used to open a position, and the Short is simply the opposite order, and used to close a position.
- The closing order is simply the opposite of the opening order, and is sometimes called a “Sell/Buy/Sell”. Using the “Create Closing Order” tab or similar, place an order to Sell the same strikes you bought with a Debit, and Buy the strike you sold as credit—but all in one transaction.
In the GOOGL case, the closing order would be
SELL -1 905 Call
BUY +2 910 Calls
SELL -1 915 Call
For the SPY spread, the closing order will be
SELL -1249 Calls
BUY +2 250 Calls
SELL -1 251 Calls
As the trade approaches expiration, remember that any positions which will be in-the-money at expiration should be closed. You can let out-of-the-money options simply expire out-of-the-money.
There can be trouble ahead if you do not close out your butterfly positions before expiration. Any legs of a spread which are in-the-money at expiration can be exercised. That means you will be assigned stock, and you will pay extra fees for that assignment. Brokerage firms also have the right to handle that exercise any way they wish, including the right to sell that assigned stock and charge you another set of fees. They can even sell your assigned stock for less than you paid and cause a further loss to your account. The lesson: close out all in-the-money legs before expiration.