Advanced Butterfly Spread Strategies

06/29/2011 6:00 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

A real trade example shows that a complex butterfly option strategy can be made easier to comprehend and execute by breaking it down into two separate vertical spreads.

This article will examine the specifics of a butterfly trade that one of our students had recently taken without truly knowing what he did. Option strategies can quickly get quite complicated, so it is important to know what you are buying or selling before entering the trade.

This is what he wrote to me:

Hi Josip,

I have placed a trade that I never properly understood. It is a put butterfly and it seems to me that I have made some money on it, I just do not know how and why. Especially because at the exit, I didn't know how to take it off and the broker closed it for me as a back ratio spread. I have no clue how I ended up with the back ratio. I am completely confused by what I did. Could you kindly enlighten me? Any insight is appreciated. Thanks a lot. Below are the facts.

He placed the 41/43/45 put butterfly on the iShares FTSE China 25 Index ETF (FXI) on May 25, 2011. For simplicity's sake, I have created the table below showing specifically each leg of his trade.

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Let us address the specifics of each leg: The 45 strike and 41 strike prices were bought, so $1.73 (for the 45 put) plus $0.18 (for the 41 put) brings the cost to $1.91, but at the same time, two contracts of the 43 strike price were sold for $0.60 each, bringing in a credit of $0.60 and producing a total credit of $1.20.

Hence, the difference of these two amounts ($1.91 - $1.20) produces a net debit of $0.71, which is exactly how much he was paid to be in this trade.

He mentions that the trade was exited by his broker as a back ratio spread. A back ratio spread consists of a long option that is offset by two short options that are further out of the money. The only difference between a back ratio spread and a butterfly is that the butterfly adds a long protective option that is even further out of the money than the two short options.

The closing date he provided was June 17, 2011, which was the June expiry Friday. I checked where FXI closed, and it was at $42.08. He would have made the maximum profit if FXI closed at $43 even, but it did not. The table below lists the legs that were in the money.

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Going through the closing trade, focus needs to be placed on the difference between the credit received ($2.94) and debit paid out ($1.94). The leftover money ($1.00) was what the closing of the put butterfly as a back ratio spread brought in. Notice that no action was needed to be performed on the 41 put because it was completely out of the money and worthless.

When the student says that he “thinks” he made money, he is actually right. The whole trade was initially done for a net debit of $0.71, and when the trade was closed, the credit received equaled $1.00, so what was made at the end was the difference between the two ($1.00 – $0.71 = $0.29) minus commissions, of which there were seven; four at the entry and three at the close of the trade.

Now, let me say that there is also a possibility of looking at the same trade through completely different lenses.

Although the results are going to be identical, I found that many of my students are able to understand a butterfly more easily as two vertical spreads, rather than a single structure. Hence, for their sake, here is the alternate view of the same trade.

NEXT: A Put Butterfly as Two Vertical Spreads

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A Put Butterfly as Two Vertical Spreads: Entry

What was originally put together in Figure 1 is now broken down into two separate pieces: The debit put in Figure 3, and the credit put in Figure 4.

Also, observe that each table has three different labels to show the three different names for these particular vertical spreads just to make sure that no one gets lost in the terminology of the spreads. The goal is to demystify what the trade really was; not to make it more complicated.

In a nutshell, a bear put by itself has the aim to see that the price of the underlying drops down to (but not below) $43, which would mean that the 45 put has gained in value while the 43 put—as long as the price is above it—would actually expire worthless.

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Once again, it is beyond the scope of this article to teach the intricacies of vertical spreads, so I suggest that readers interested in more details about these read my previous articles, Vertical Spreads: Part IV and Basics of Vertical Spreads.

Now we move on to the bull put, in which case the 43 put was sold and the 41 was purchased as a form of insurance without the intention of seeing the 41 call being in the money at expiry.

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The bottom line is that the cost of the bear put was $1.13, while the credit received from the bull put was $0.42, and the difference between the two ($0.71) is the total cost of the trade, which is exactly how much the student has paid for the butterfly transaction.

A Put Butterfly as Two Vertical Spreads: Exit

Next, let us look at the exit of each vertical spread.

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The first two columns give us the same data as Figure 3, but in the third column, we see the closing action for this strategy. The long 45 leg was sold for $2.94, which is more than it was initially purchased for ($1.73), hence, we can conclude that the 45 put was the driver of this spread because it made $1.21 ($2.94 - $1.73). Nevertheless, the 43 call did not expire worthless because the underlying had moved well past 43 and ended up closing at $42.08.

The sold 43 put was repurchased for more than what was paid for it, causing a loss of $0.37 which is subtracted from the profit on the 45 put, which was $1.21, giving us a net profit of $0.84. By the way, we could have arrived at the same conclusion with the differences from the last row: The closed trade for $1.97 minus the open trade for $1.13.

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In the case of the bull put, the trade did not work out so well since it was closed for more ($0.97) than it was sold for ($0.42), creating an aggregate loss of $0.55. This bull put loss must get subtracted from the bear put gain of $0.84, and the same conclusion is made: The profit was indeed only $0.29 ($0.84 - $0.55).

To reiterate how a butterfly can be closed with selling a back ratio spread: If you put the two spreads (bull put and bear put) back together into the butterfly and look at the actions needed to be done to close the butterfly, you will see the closing of a back ratio spread.

You would only be closing the puts that are in the money, the long 45 put and the two short 43 puts. The long option and the two short options further out of the money would then expire worthless.

In conclusion, we have demystified the put butterfly exit as a back ratio spread by looking at the butterfly as two vertical spreads.

By Josip Causic, instructor, Online Trading Academy

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