In the language of options, any trade that involves more than one option is called a “spread”. Two paired options can be called a Vertical or Straddle or other names, and four options make up a Condor. There are many variations on these arrangements, and they are covered in any course in the fundamentals of options trading. Here is my primer on the basic Butterfly spread.
1. What is a Butterfly Spread ?
The Butterfly is a type of option spread with a distinct design:
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- three legs (“body” and “wings”)
- three different strikes
- equal number of long and short contracts
- either all Puts or all Calls.
You will quickly notice that the Butterfly is unique. Unlike a Vertical spread, which has two legs, or an Iron Condor, which has four, the Butterfly has just three. For that reason, it requires special knowledge and practice to perfect.
The Butterfly uses either Puts or Calls, not both. So you will hear traders speak of a Put Butterfly or Call Butterfly.
2. Why is it called a Butterfly?
The first feature of the Butterfly is the simple structure of three legs, sometimes referred to as “body” and “wings”. Like a real butterfly, the center or anatomy is the most important part, while the wings provide stability.
Each leg corresponds to a “strike” or price point, creating a spread such as 120, 121, 122. (They can be either Puts of Calls, but not both.) The Butterfly is balanced with an equal number of long and short contracts. The central strike is assigned twice as many contracts as the outside strikes such as +1 -2 +1 or maybe +5 -10 +5.
In a standard Butterfly trade, the body or central leg is the money-making part. The wings provide insurance against loss in case the stock price moves up or down. In other kinds of trades (such as Strangles or Iron Condors), we refer to different strikes as “legs” but that might be confusing here. So from here on, we will usually refer to the body and wings, just as you see in the photo here.
Image: Crimson Rose Butterfly
3. What are the special advantages to the Butterfly?
The Butterfly is a trader’s delight because it seems ideal, solving many of the obstacles faced by other spreads. The special benefits to Butterfly Spreads include
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- low, defined-risk,
- low entry cost
- high potential profits.
- highly repeatable
Puts and Calls on stocks can be expensive, especially on higher-priced stocks. The Butterfly solves this problem by buying and selling an equal number of options at the same time, using three different strikes. Each spread can be bought as cheaply as a few dollars and the profits can potentially run into a hundreds or thousands of dollars. You can theoretically make five or ten times your investment, and do it every week. Your loss is limited to the purchase debit plus commissions. Money and time spent learning and practicing them can pay off very well. No wonder Butterflies have become the favorite of many experienced traders.
4. What are Long and Short Butterflies?
Just like any spread, Butterflies can be Long (bought for a debit) or Short (sold for a credit). These terms refer to the spread as a whole, not to any specific parts of the spread.
The Long Butterfly spread can be bought for any amount above 0.0 cents and sold for an amount up to the maximum available credit (MAC).
The Short or Reverse Butterfly is constructed the opposite way: the central strike is long and the wings are both short. This spread can be sold for any credit above 0.0 cents. More on this spread later (see under “Reverse Butterfly’).
Table: Long and Short Butterflies
5. How is a Long Butterfly constructed ?
Traders usually identify Butterflies by where the middle strike is located. With the “sold” strike sitting in the middle, the long/buy strikes each side or “wings” are there to insure against loss and reduce margin requirements. Depending on the strategy in use, the distance between strikes can be manipulated, creating either a wide or narrow butterfly.
For the Long Butterfly, the three strikes are arranged as a “Buy/Sell/Buy”. So a NFLX 160 Long Call Butterfly will have the short strike at 160, and be constructed as 157.5 (long) /160 (short) /162.5 (long).
Another example: imagine we are designing a GOOGL butterfly, centered at the $905 strike, using $5 wide strikes.
Wing Body Wing
$900 $905 $910
BUY +1 Call SELL -2 Calls BUY +1 Call
In thinkorswim, this order is usually GREEN in color, representing a debit (credits are in RED). Here is the order for this GOOGL spread, at a cost or debit of .10 cents.
This would result in a symmetrical trade which will return profits if GOOGL’s stock price is close to the center strike of $905 at expiration.
6. What does a Butterfly spread look like?
Visual representations or graphs of spreads are very useful tools, providing lots of information at a glance. Most trading platforms offer some kind of graph such this one by thinkorswim.
Let’s review our example of Butterfly on GOOGL in TOS’s Risk Analyzer. On the left is the Profit/Loss scale, and the bottom scale tracks the expected stock price. The triangle shape created by the green line represents the potential profit or loss. The purple line represents original value, and the green shows the value at expiration. Closer to expiration, the purple line will approach the green line, showing the profit, which could be as much as $400.
Reading the Risk Analyzer for Profit/Loss
Highest profit would be achieved if at expiration the stock is at the 905 strike where the “body” of the butterfly is placed there. The trade will make money as long as the price is within the two break-even marks (the short red lines where the green line intersects the zero line). The maximum loss would be $10.
7. Where does the profit come from?
Because an investor is always willing to pay more for at-the-money options, they are more expensive than out-of-the-money options. When a trader sells those options to the investor, the trader collects premium based on the time to expiration. So the profit comes from options which are sold and then decay in value.
In the GOOGL example above, this means the 905 Put and Call are more in demand than other strikes. Buyers of Call options might pay, say $7 for that option. The seller of the option would generate a $7 credit. If the stock price closes at or below 905, the Call option would be worth nothing and the seller of the option keeps the $7, making maximum profit. The trader has made all the profit and the investor has lost their entire investment. Similarly, an investor might pay $8 for a 905 Put. (This would be a form of protection against a drop in the stock price.) This same Put could expire worthless if the stock fails to drop below 905. If the trader sold both the Put and the Call, she would generate a $15 credit.
In short, profit comes from other traders who pay money (premium) for the right to hold an option at the chosen strike. The time value of this options drops to zero, or it expires worthless. The buyer’s loss is the seller’s gain.
EXTRA: The fixity of strikes and the inevitability of time decay are the essential ideas behind Butterflies. The time value of options (known as theta) is constantly decreasing, so by selling this premium (the short strikes) at a high price, and then a few days later buying it back cheaper, or letting it expire worthless, we create profits. Maximum profit occurs when the option at the center strike expires at-the-money. This effect occurs only in the final week or day of an option’s life.
8. Why are there two other options, one each side of the short option?
Short or sold options incur considerable risk to the seller. Price could move far beyond the expected strike, incurring a loss, and so brokerage firms require protection of any short position. The trader therefore buys an equivalent number of long options as insurance against loss. Placing the long options each side essentially limits risk to the amount paid for the spread, without actually touching the center strike, which is the money-maker. The value or cost of any spread, therefore, is the net balance between long and short options.
Options which are at-the-money are always the most expensive for the time value they offer. The wider the strikes, the more expensive the spread will be. But eventually the premium sold will reduce to zero. Profit is income from time decay of the center strike or body.
But where does the money come from?
Imagine you were offered a beautiful mounted butterfly for no money, including a clear glass box for viewing. Then a days later someone else offered you good money for it and you sell it—butterfly and protective box. That’s essentially how the Long Butterfly Spread works.
The secret is to buy the whole Butterfly Spread as cheaply as possible, and sell it all for a good profit.
9. How is profit made?
The same way you make profit in any business or transaction. You buy low and sell higher—or sell high and buy lower. The difference between the two is your gross profit.
It is important to recognize that a Butterfly Spread is a package, and needs to be bought and sold as a package. Don’t try to separate out the legs or treat them independently. So when you are considering profit, then the reference is to the whole spread, all three legs.
Simply buy a Butterfly Spread (a Debit) and sell it for a higher price (a Credit), as in the following
Buy 1 Long PCLN 1550 Butterfly .20 ($20)
Sell 1 Long PCLN 1550 Butterfly 1.00 ($100)
___________________________________
Gross Profit .80 ($80) (before commissions)
10. Are there different kinds of butterflies?
Yes, there are many kinds of butterfly spreads, suited to different market conditions and investment objectives.
Long Butterflies are generally those which require an investment by the trader. They are constructed with the middle strike short, accompanied by long strikes either side.
Short or Reverse Butterflies employ the opposite strategy, and the trader receives a credit. The construction places a long strike in the middle and a short strike each side.
The Reverse Butterfly is also the closing trade of a Long Butterfly.
In addition, there are variations in strike placement, known as the Jade Lizard and others. More on these in a later chapter.
11. Can another spread be substituted for a Long Butterfly?
A similar spread—with a short middle strikes and long strikes each side—is the so-called Iron Fly (or Iron Butterfly). It is constructed with both Puts and Calls, and in reality is just an Iron Condor with a common middle strike. Astute traders will notice that it is also the same as a short Straddle, but with insurance legs added.
The difference is that it is almost impossible to put on the Iron Fly without increasing your overall risk. To read more on this spread, go to the chapter “Iron Butterfly”. However, it is useful to know for those moments when you can safely add it to your account.
In short, a butterfly uses either Puts of Calls. An Iron Fly uses both Puts and Calls.
Iron Fly at the 350 Strike
12. When is the best time to trade Butterflies?
Like all spreads and strategies, there are good and bad times to use any particular strategy. Traders learn to match strategies to market conditions and profit objectives.
Butterflies do best under certain conditions:
- In less volatile markets. Eventually the price of a stock will settle somewhere, but it is very hard to know where that will be, when the market is jumping up or down. Its usually not cost effective to buy twenty Butterfly spreads in a volatile market while hoping that one will be a winner. But four or five are manageable.
- Whenever there is an expiration approaching. Option premiums expire every month, and on some stocks every Friday. That means there are opportunities every week to trade butterflies on many stocks. We usually buy butterflies up to one week in advance of expiration and close them within a day or two of expiration.
- Between earnings announcements, and not during the week that earnings are announced. The time of earnings is when there stock is most volatile, making a “pin” very difficult. Some stocks jump $100 or more, and you’ve wasted all your money buying Butterflies so far away from the new stock price.
- When and where everyone else is trading them. If the Volume and Open Interest are low, then there will be no one else to play with. However, as we almost always trade Butterflies close-to-the-money, we are choosing trades where volume is high.
- When it is appropriate for the strategy you are using. There are several Butterfly strategies, and each one has an ideal time horizon. Long butterflies, for example, are most often bought away from the current stock price, and sold at the current stock price.
Obviously there are also “the worst of times,” as Dickens once wrote. I’m sure you can figure out what those would be. Clue: the opposite of the above, or buying when they are most expensive and selling them when they are cheapest.
13. What are the potential profits and losses?
Every Butterfly has limited profit and limited loss. If you are looking for unlimited profit, then try different strategy such as a single Call or Put. (I haven’t met anyone who made “unlimited” profit on a trade yet!).
Let’s look at our GOOGL Butterfly. Again The key money-making tool is the short 905 strike. The two long strikes at 900 and 910 act as insurance to cover the short 905 strike and reduce margin requirements to zero. In this case, the cost is .10 cents, or $10 plus commissions for one contract. With this trade, the only possible loss is the cost of the trade, including opening and closing commissions and debits. More on this later.
The option will expire with maximum profit of over $400 if the stock rests at $905 at expiration. The trade will lose a maximum of .10 cents per share or $10 if the final trade price rests outside the $901-909 range at expiration.
Of course, the ideal outcome here would be if the loss was zero, and the option was sold at maximum price. But that doesn't always happen, and it sometimes good to just get half the available profit.
14. Which stocks can Butterflies be traded on ?
Theoretically, any stock or index with options can support Butterfly trades. We prefer stocks with moderate volatility as these generate higher premiums. The features we consistently look for are:
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- share trading volume of 500,000 per day
- weekly options when available
- at-the-money strikes with widths of less than 1% of stock price
- open interest of 100+ at the strikes we wish to trade
- overall low market volatility (VIX under 15)
- tendency to “pin” to a strike
- no earnings before expiration
- the higher priced the better
Some stocks simply disqualify themselves. Those with strikes $20 wide, or with low option volume (these two seem correlated) are poor candidates. Most stocks under $50 do not qualify, unless they have strikes .50 cents wide. Many pharmaceuticals and stocks with extreme Beta values are excluded because their price behavior is unpredictable.
Unfortunately, many favorite stocks also do not qualify for Butterfly trades. BLK is a relatively stable stock whose price mimics the SPY but its strikes are $10 wide—about 3% of the stock price. Although C (Citibank) is priced around $60, its at-the-money strikes vary each month, from .50 cents to $2.50—and no one I know can explain why!
The higher priced the better? Yes, because although the cost of the trade (up to .10 cents per spread) remains the same, more expensive stocks offer vastly higher credits. Here are some stocks and indices that usually pass the test.
- PCLN, AMZN, GOOGL, GOOG, ISRG, BIDU, BIIB, AAPL, NFLX, TSLA, IBB, SPY, SPX, NDX, RUT.
15. Should Puts or Calls be used?
There’s a lot of opinion on this question. Here is my rule: use Calls for spreads above the current price, and Puts for spreads below. This produces an array of out-of-the-money Butterflies. The main benefit is that most of your spreads will either close for a profit or expire out of the money, and you not have to close them. This saves on commissions.
But other considerations might force the trader to break this general rule. Some traders say that orders for in-the-money options are more easily traded. This would require you to face your options toward the current price, rather than away as in the rule above.
Sometimes either Puts or Calls are more heavily traded. If you don’t get fills using one, try the other. Keep accurate records of your fills and it should not be a problem.
However, if you fail to close out a Butterfly, it makes a big difference if its Puts or Calls. Remaining short Puts will result in an assignment of Long stock. Remaining short Calls will result in stock being called away from you. In either case, you will need to have insurance already in place to handle the assignment, even if you intend to close the trade in a day or so.
16. What are the commission charges?
Trading butterflies consumes a lot of commission fees, as they must often be both opened and closed. That’s six “legs” or positions times number of contracts per round-trip trade. If your brokerage company charges a flat fee plus 0.75 per contract per leg, the fees can quickly run up. You should anticipate the cost of commissions when you calculate the total profit and loss.
One way to reduce the commission costs is to ask for free trades whenever you open an account, or if you add money to your account. Check what “deals” are available—including deals from other brokerage firms. Its generally true in life: you get what you ask for, but if you don’t ask you don’t get anything! So remember to “ask and it will be given to you.”
17. How do I calculate my profit and loss (after commissions)?
Here is the trade ticket (showing green for debit) for the opening trade of a PCLN Butterfly. The total debit would be $50 plus $9.95 or $59.95.
To close the trade (showing pink for credit), we have chosen a selling price of $1.00. The trade ticket for this closing order shows a credit of $100 minus another commission of $9.95, or $90.05.
The Net Profit after the Buy-and-Sell would be $90.05 minus $59.95, or $30.10. As you can see, commissions can mightily eat up profits. You are probably best to try them out when you have some commission-free trades, or when you can afford to risk more contracts. If you do 10 contracts, that’s about $905 minus about $60 in commissions for a net profit of $845.00. Big difference!
Step-by-step instructions on opening and closing Butterflies using thinkorswim.
With this knowledge, you can more easily decide how much risk you will take per trade.
(From Graeme's new book.) All rights reserved. Copyright 2017