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Prologue

I am confused by the cacophony of misinformation about butterfly spreads permeating discussions right now. I don't have any understanding of the motive people have for spreading false rumors and information about trading strategies, other than it being confusion or a lack of understanding on the usually well meaning (but sophomoric) filibuster's part.

When first undertaking a journey into the powerful world of option trading, it is easy to be overwhelmed; a new language and new concepts are being undertaken. However, once the student gets an intermediate understanding of the instruments being utilized the real journey begins. The walls of confusion come crashing down, concepts start to lose their ambiguity and a solid understanding forms. It is at this juncture that the real learning begins. It is a magical and exciting time when your gaze at the light at the end of the tunnel doesn't seem as if the photons are an infinity away, and you start to see the riches on the other side. I absolutely love seeing it in the faces of traders when they reach this point. Optionetics.com’s and my goal is to get you there, which is the purpose for this article.

I am addressing the concept of using other trades to hedge a butterfly. In a previous article I spoke of the misuse of calender spreads. I am now hearing that people are using said time spreads to hedge a position called a butterfly. The belief that a butterfly has to be hedged, protected, babysat, manipulated is very frustrating as this is a misconception. What is even more absurd is that this is being done on butterfly positions with a long time until the completion of its expiration cycle.  A butterfly by definition is a hedged position. Not only is it a hedged position, but it is so hedged as to be inert usually until about the final week or two of expiration.

First, I will define a butterfly. A butterfly is the simultaneous purchase and sale of two vertical spreads (either call or put) where the sale portion of each spread share a common center strike. A long vertical spread is the purchase of a closer to at-the-money [ATM] option and the sale of a further out-of-the-money [OTM] option used to lower the cost of the original option purchase. A butterfly spread is the same concept at work as with a vertical spread – risk and cost reduction. With a butterfly, instead of purchasing one option and selling another to lower the cost (vertical spread), one purchases a vertical spread and sells another vertical spread to lower the risk and cost. It is a vertical spread on steroids, if you will. It is the Arnold Schwarzenegger of vertical spreads.

An example of a medium-term butterfly can be discussed for our purposes using an index called the Standard and Poor's 100, or OEX. We will use the June options, which leave us 77 days until expiration. 

The index is currently trading at approximately $590. I will use real time quotes to support and illustrate the concept of how this position is a perfect hedge, and it is not in need of protection.

The option chain and greeks look as follows:

Butterfly Construction

The long butterfly consists two spreads combined. The first is that of a long 610-615 call vertical where one buys the 610 call and sells the 615 call. The second is the sale of the 615-620 call spread where one sells the 615 call and purchases the 620 call. The purchase of the long vertical will result in a debit. The sale of the second spread results in a credit. The difference between the debit paid and credit received is the cost of the butterfly. Using the above prices ($4.30, $2.95, and $1.80 respectively) we get the cost of the butterfly being a $0.20 debit as seen below. 

Notice that the cost of a vertical spread as described above is $1.35 per share. This is a good trade in itself, but when combined with the sale of the other vertical spread our maximum cost and risk goes down to $0.20. That is the power of a butterfly and why people stand in line to learn these powerful strategies. The problem is that there is a misunderstanding as to what the trade is.

Thinking the position through logically we would want the underlying to close at a position where we make the maximum on the long spread (which is a price of $615 or higher), and where the short spread expires worthless (which is a price of $615 or lower). If we want the underlying to close simultaneously at a price of $615 or higher, and a price of $615 or lower, we instinctively know that we want the index to close at $615. Obviously the likelihood of this happening is remote, but if the index closes anywhere in the range between the extremes of the strikes we make money! 

But does a position such as this need hedging? Absolutely not! The chart below shows what the butterfly looks like when the option greeks are taken into consideration. Delta, gamma, vega and theta are about as neutral as one can make a position, thus no hedging is needed or even desired. Hedging something with a risk of $0.20 and no greek/risk exposure is like insuring a brick against fire. 

Notice that the delta of this position is zero. Also, the net gamma of this position is zero. I need not continue. Also, the net theta(time decay) of this position is close to zero with a net positive theta of $0.01. This means that this position loses $0.01 a day as expiration approaches, but this is a little misleading. The position should actually be theta neutral but is off slightly due to the rounding error of the greeks as calculated by the option pricing model of the software.

Conclusion

There is no need to hedge a position such as this – period. Anyone saying otherwise is simply incurring additional commissions, doesn't thoroughly understand the butterfly, is trying to justify placing another trade unnecessarily, or confused. The butterfly is an excellent strategy used successfully by most floor traders and definitely worth the investment in time trying to learn the position. Like any tool, it is only as good as the knowledge of the user, and as such should be studied by those wishing to employ the awesome investment strategy. I hope this helps pave a better understanding to your road of success.


Scott Kramer
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
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