02/26/2010 12:01 am EST

Focus: OPTIONS

This article is a follow up to the previous articles, How To Trade Butterfly Spreads: Part 1 and Part 2 , on the specifics of the call butterfly. I highly suggest that those who have not read the articles mentioned above click on the links provided and take the time to look over those articles as well.

As I have initially explained, option traders would typically place butterfly spreads when they are not anticipating huge movement within the specific time frame, however, anyone watching the market over the last week or so knows that the market has made a major move to the downside. At this point, it is so easy to say: "Ironically, the market has done exactly opposite of what was originally anticipated." Yet, I believe that every trade, regardless of its performance, should be used as an opportunity to learn.

When the initial trade was placed, the underlying was chopping around in a range between the \$45 zone and the \$41 zone. The expectation was that most likely, the underlying will be trading at expiry somewhere within the \$43-zone, or within a few pennies up or down. Figure 1 below lists the contracts and the premiums at the point of entry.

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By buying this spread, I have created a long February 41/43/45 call butterfly for a debit. What follows is specifically what took place leg by leg. First, I was long a single contract of the February 41 call at the asking price of \$2.46, as well as being long a single contract of the February 45 call at the \$0.51 ask. These two contracts cost me (\$2.46 + \$0.51) a total of \$2.97.

I also have a short position. I sold two of the February 43 calls for a credit of \$1.13 (2 times \$1.13 equals \$2.26). The difference of the long and short contracts, \$2.97 - \$2.26, produces a debit of \$0.71.

The maximum profit of a butterfly is calculated by subtracting the distance between the wings (45 call minus 41 call equals 4), dividing it by two, and then subtracting the debit from it. So, \$2.00 – \$0.71 = \$1.29. Hence, the most that we could make is \$129, while the most that we could lose is only what we paid for, \$71, and not a penny more. This position has both limited reward (\$129) as well as limited risk (\$71).

The call butterfly internals presented above could be chopped up another way. A butterfly is nothing else but a bear call and bull call combined into one single structure. Below is shown the bear call part of the trade, followed by the bull call part of the trade. All the possible names for these two vertical spreads are used to ensure that the readers understand that a bear call, as well as a bull call, has many various labels.

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For the bear call, the chart above lists a max profit at \$0.62 and a max loss at \$1.38.

Next let's look at the bull call side of the trade.

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Bears and Bulls

In the case of the 43/45 bear call, the option trader keeps the maximum profit, or credit of 0.62 per contract, if the underlying closes at or below the sold 43 call. In the case of the 41/43 bull call, the intention of the trader is to see the underlying trade and close at or above the 43 call.

If the underlying closes at the point of maximum profit for both spreads (43), \$0.62 for the credit spread and \$0.67 for the debit spread, then the amount of \$1.29 is obtained, which is exactly what we originally calculated as the 41/43/45 call butterfly max profit.

In the case of the call butterfly, the maximum profit is achieved if the price at expiry is at the middle price, in this case at the February 43 call. In my option classes, I often refer to this phenomenon like this: "The Butterfly landing at the tip of the flower (the February 43 call) is the most profitable."

Having explained the most desirable point where maximum profitability is obtained, let me move on to the explanations of two unfavorable scenarios.

Scenario One: Maximum loss realized at expiry if the underlying is trading at or below the lower 41 call strike price. Below, we can see an example of this.

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Scenario Two: Maximum loss realized at expiry if the underlying is trading at or above the upper 45 call strike price. Following is the illustration of this.

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At the time of writing this article, the underlying on which this call butterfly was placed has dropped all the way to \$39.04 and the premiums quoted the following: The February 41 call is at \$0.375, the February 43 calls at \$0.095, and the February 45 call at \$0.03. This example was for educational purposes only, therefore, we left off the identity of underlying. When using an example for educational purposes, there should be no attachment to the outcome—so is the case with this trade.

In Conclusion

In conclusion, this article has presented the intricacies of the call butterfly structure in two different ways. One simply as a butterfly, while the other one as a combo of two call verticals. When trading butterflies, be aware of the fact that their lower and upper BEPs are the debit plus the lower strike and the upper strike minus the debit.

Also, keep in mind that butterfly spreads are meant to be used in directionless markets and that current market conditions do not support the strategy described in this article. Have green trading!