How to Trade Butterfly Option Spreads

03/13/2013 1:00 pm EST

Focus: OPTIONS

Steve Smith

Reporter (Options Columnist), Minyanville

Steve Smith shows how you can use butterfly spread option trades to make money on directional moves.

My guest today is options expert Steve Smith, and we're talking about butterfly spreads; what they are and how to use them as an option trader.  So, Steve first of all define what a butterfly spread is.

A butterfly spread is traditionally constructed of its two spreads basically stacked on each other, so you're buying a vertical spread and you're selling a vertical spread on top of it, and in between you have the common strike and that defines the body, the outside strikes are the wings.  It's a low cost way to basically bet on a directional move, but low cost also means low probability.

Alright, talk about the directional move.  How much should it move for me to make the most money?

Well, it would depend on the strikes you choose and probably the biggest drawback of butterflies is that you can't really profit until you get very close to expiration. Because you're both selling and buying spreads, you're basically diminishing the immediate impact of both time decay or theta and volatility because they offset each other, so it really comes down to that last week towards expiration.

If you say last week then how about weekly options in using this?  Is that a good idea?

That's a tremendous idea, and I do that quite a bit, especially around earnings time.  One of my favorite things to do is-this is a selective thing, no pun intended-but it's not a bread and butter like people like to buy rights, oh you know, covered calls over and over.  This, you have to be selective about.  Using weekly options when an earnings release is coming out is a great way to put on a low cost directional position.

Yeah give me an example of that, if something is maybe announcing earnings on a Friday or a Thursday.

You know what, Google for whatever reason they tend to always announce their earnings on the Thursday before an expiration, but you also have a lot of the other popular stocks now like you said that have weekly expirations. But going way back Google, before there were weekly options, always had Thursday.  You would be able to put on let's say something that has a $20 or $30 width between the call that you're buying or whatever it may be which depending on the direction width, so your profit potential is $30 and maybe it cost you $3, so that's a great payoff.  But, of course you really have to get it right within that range.

So are you assuming that it's going to stay in that range after earnings?

Well, I usually do something a little out-of-the-money and hope that it moves, usually the options are pricing in a 6% or 7% move and that's one of the ways you can try and target what strike prices you might want to use; what are the options pricing in, and say okay this what I agree.  Option traders are pretty smart, so they usually get a pretty accurate where it might go after earnings. 

Alright, so the expiration is taken care of because its right or a week before the strike price you're looking at the options chain and seeing which ones you think is the best deal.  How do you go about doing that?

It's again I would use a combination of what it's being priced in and then maybe a little bit of chart work in terms of where the support and resistance might be both on the up or down side, and then open interest because we know it sometimes tends to get a little bit of that pinning action at expiration that if there's large open interest, so you'd gravitate towards trying to have your maximum profit at a strike price that is both a combination of the three things; open interest, the implied move, and where the technical support of resistance might be.

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