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10/13/2014 8:00 am EST
Option trader Michael Thomsett of ThomsettOptions.com outlines the fundamentals, as well as the pluses and minuses of using butterfly spreads in option trading, namely, limiting potential profit in exchange for limiting maximum loss.
When traders begin checking out the many ways to use options, the spread presents the greatest opportunities, as well as challenges. But don’t let the gentle names fool you. For example, the butterfly sounds like a soft, gentle strategy, but it might not be after all.
The butterfly is a complex strategy, so complex in fact that it might not provide enough profit potential to justify it. The position is made up of a bull spread and a bear spread, opened on the same underlying security at the same time. This tends to limit risk and requires very little net payment. But in exchange for this limited risk, maximum profit is limited as well. The ideal outcome takes place when the underlying price does not move too far or too fast.
You might prefer butterflies over other spreads as long as you want to limit maximum loss in exchange for also limiting potential profit.
In the butterfly, you are going to use three strikes. For example, a stock closed at $80.27. You could set up a call butterfly with the following positions:
The butterfly in this example cost $72 (plus transaction fees). Although this example used calls only, you can also create a butterfly using puts. In either case, you end up with a small middle zone profit and outer loss zones above and below.
In the case of buying a 77.50 and an 82.50 call and selling two near at-the-money 80 calls, a trader will lose $150 at the most, or earn a profit of $250 at the most:
In this example, you spend $72 plus transaction costs. You have a chance of earning a profit if the stock ends up between $79 and $81 per share. If the price is lower than this, you lose $72; if higher, you lose $22. So the judgment you have to make is whether the exposure to limited loss is worth the opportunity for limited profit.
Realistically, these profits or losses are not always going to be realized. As soon as any of the positions among these three strikes become profitable, that portion of the butterfly can be closed. This occurs on the short side due to time decay or on the long side due to increases in the underlying price above strike. However, this raises a new and unexpected risk. You could end up closing the long sides for a small profit and end up with uncovered short positions. In this case, an assumed conservative trade could result in a leftover that is quite high-risk.
Otherwise, an astute trader will not allow that to occur. In this case, the butterfly can be a low-risk strategy that also offers very limited rewards. You might gain higher profits with less complex strategies including many other types of spreads.
By Michael Thomsett of ThomsettOptions.com
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