Butterfly spreads are probably the most well known and popular option strategies to choose from today, mainly because they are often referred to in option trading books. They perform best when a stock is recognized as trading within a clearly defined range for a period of time. There have been two prevailing schools of thought on identifying range trading stocks.

1. Locate a stock which has been trading within a range over at least 3 months, preferably longer. This type of stock is more likely to stay within that range in the forseeable future. In other words, you should stay clear of trending stocks. But take care! There is a difference between range trading stocks and those whose price action is narrowing into a triangle pattern (lower highs and higher lows converging). These patterns often precede a strong breakout and therefore are more appropriate to straddle trades than butterfly spreads.

2. Find stocks which have recently made a major move which included a huge volume spike. This usually takes place following news announcements or takeover bids. Following this type of move, the stock is likely to settle into a range for a couple of months, unless the news that caused the spike in the first place is negated (e.g. a takeover bid is retracted and the price falls to prior levels)

Once you have identified such a stock, you are almost ready to implement your butterfly spread. First, you then should locate support and resistance levels at the extremities of the expected trading range, then you should identify option strike prices in relation to those levels. Finally, you would ideally like the stock to be currently trading near the middle of the above support and resistance levels when you place the trade.

Setting Up a Butterfly Spread

A butterfly spread is basically a combination of a vertical debit spread and a credit spread sitting directly on top of each other but with a common mid strike price. So all up, you have 3 strike prices. The two outer points are called the ‘wings’ while the middle strike price is the ‘body’ of the butterfly. The idea is that you ‘buy to open’ one option contract of each wing and ’sell to open’ two contracts for the body.

It is possible to construct your butterfly spread with either call or put options but not both. Let’s ?magine we’re working with call options, in which case:

Your two ’sold’ positions will be ‘at the money’ (ATM)

Your upper ‘bought’ position will be ‘out of the money’ (OTM)

Your lower ‘bought’ position will be ‘in the money’ (ITM)

If you used put options, your sold positions would remain ‘at the money’ (ATM) but your upper and lower bought positions, as above, will be reversed.

Using either call options or put options would achieve exactly the same result, so when assessing which to select, you should target the one that provides the superior return on risk. Ideally, you should go for option contracts with 1-2 months to expiry.

Characteristics of a Butterfly Spread

One of the most attractive characteristics relating to this option strategy is the potential return on investment. If you can find a range of option contracts for three strike prices that minimize your initial cost, you can be looking upwards of 300 percent at expiry if the underlying stock closes at the maximum profit level.

Prior to placing such a trade, you need to do your sums. You must know:

1. Your maximum profit potential

2. Your maximum loss (which is limited to the initial cost) and

3. Your breakeven points

Your maximum profit at expiry will be the difference between the ‘wing’ strike price and the ‘body’, minus the cost to enter the setup. So if your 3 strike prices were $5 apart and the whole spread cost you $1 to enter, then your maximum profit would be $5 - $1 = $4 per share per contract, which is 400 percent return on risk. But if your 3 strike prices were $10 apart and the entry cost was $3, then your maximum profit would only be $10 - $3 = $7 which is only 233 percent return on risk.

So analysis of the trade’s potential before entry is critical. You need to look for the best potential profit opportunities and this means paying attention to your initial cost.

Breakeven points at option expiry are places where, if the stock closes, will make no profit or loss. These points are calculated as one of the two extremities of the spread, less the initial debit paid.

How Much Collateral Do You Need

To enter any option trading position you need to have sufficient funds in your broker account. You will need enough to fund the vertical debit spread section of the trade, plus enough again to cover the difference between strike prices for the credit spread component. This means less capital will be available for other trading opportunites. Using the case above where strike prices are $5 apart and assuming 100 shares per option contract, you would need $500 $75 collateral, plus brokerage costs, to do your butterfly spread.

Implementing the Strategy

Most butterfly spread examples you’ll read about will give you potential profit levels at expiry date. But you don’t have to wait till that time to exit the trade. As the expiry date draws near you should assess the probability that you can take profits. As previously mentioned, the maximum profit level is achieved when the stock closes at the middle option strike prices at expiry date. But during the last 3 weeks of the trade, the profit level potential increases exponentially, as your 2 ’sold’ positions at the ‘body’ of the butterfly experience the most time decay while your ITM long position still has intrinsic value. As expiry date closes in, you should be aware of where the underlying stock price is in relation to the middle strike price. If it crosses it during that time you may wish to take an early profit. It will not be the maximum profit, but a good one nonetheless - and a smaller profit with certainty is better than waiting another week or two in the hope it will return to this maximum profit level.

Beautiful Flexibility

Let’s say you had identified support and resistance levels of a stock’s trading range and taken out your butterfly setup using call options. Within a short time, the stock retreats lower to the support level. This will mean that your 2 ’sold’ ATM positions at the ‘body’ of the trade are now OTM so you can buy them back for ‘peanuts’ leaving you with your two long calls - one now ‘at the money’ and the other way ‘out of the money’. If the stock moves back into the trading range again, your long calls will increase in value but now you will have no ’short’ calls to offset the gain.

If, on the other hand, after your purchase the stock moves up towards the resistance level, you can remember that the top level of your butterfly is actually a credit spread. This gives you the option of ‘rolling up’ thus extending the ‘body’ of the butterfly into an Iron Butterfly with greater profit potential.

    Posted in Stock market from Investor on 11. Feb. 2010