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REAL-WORLD TRADING: Float like a Butterfly, Part I

By Jody Osborne, Optionetics.com | Fri September 28, 2007 2:45PM PT

 
Trading options can seem difficult to those who are new to the game. This is especially true with the new terminology that has to be learned. With terms like condors, bull spreads and butterflies, the names of the option strategies alone can seem confusing However, once the strategy is understood, it really isn’t so confusing. Today we are going to review the popular butterfly strategy.

In order to get a better understanding of how a butterfly strategy works, we’ll use a mock trade that we can follow in real time. From time to time we will update the trade to show the options we have and how a butterfly works in the real world. This week we will discuss the make up of a butterfly, what stocks work best with the strategy and how to set one up.

The butterfly strategy gets its name from the fact that the trade is set up by selling two options with the same strike (the body) and buying one strike below and one strike above the body (the wings). All three strikes use the same expiration, which is often the front month. For example, if XYZ stock is at 50, we could enter a butterfly using calls or puts by buying the 45, selling two 50 options and buying a 55 strike. All options would be either calls or puts.

 

Figure 1: Butterfly Risk Graph

The key to this strategy is that there is limited risk and limited reward. Figure 1, above, shows that the max profit is a found at the price of the sold strike and that the max reward would be achieved if XYZ closed at 50 at expiration. Obviously, this strategy is a neutral trading strategy so we are looking for stocks that we expected to move sideways. This strategy can be used as a directional trade, although we will not discus this in this particular series.

Now let’s dissect the trade to see how the breakevens, max profit and max loss are calculated. As stated above, let’s assume that XYZ is trading at $50 and we are going use the 45-50-55 call butterfly. Below is the bid/asks for these options:

45 – 5.50/5.60
50 – 2.00/2.10
55 – 0.55/0.65

This butterfly would be created by buying the 45 for $5.60, selling two 50 contracts for $2.00 and buying a 55 for $0.65. This gives us a total debit of $2.25 ($5.60 + 0.65 – 4.00), which happens to be our max loss. No matter how high or how low XYZ moves before expiration, the max loss is still $2.25. The max reward is found by taking the difference between strikes (55-50), which is 5 points, and subtracting out the debit (2.25). This gives us a max reward of 2.75 if the stock were to close at 50 at expiration. An exact close on the body of the butterfly is unlikely, but we profit as long as the stock stays between the lower and upper strike. Below is a breakdown of these key calculations.

Max Reward – Middle strike – Lower strike – Net debit
Max Risk – Net debit
Lower Breakeven – Lowest strike + Net debit
Upper Breakeven -  Higher strike – Net debit

We know that options are priced based on various factors and one of these factors is implied volatility. Obviously, we would love to see the sold options with the highest IV, but regardless, the higher the IV, the better the max reward normally will be for a butterfly. The fact is that we like to use front month options because it gives the trade less time to move outside the profit zone. At the same time, we are expect to hold the butterfly until expiration and this means IV will have no bearing after we enter the trade.

Let’s look at an example to see how IV impacts a butterfly trade.

IV = 25
45 strike = 5.15
50 strike = 1.30
55 strike = 0.10

Butterfly cost = $2.65

IV = 40
45 strike = 5.40
50 strike = 2.00
55 strike = 0.45

Butterfly cost = $1.95

This example shows us that the higher the IV, the better our max reward becomes, so in general we tend to like stocks that are showing higher IV on its options. Of course, we need to be mindful that if IV is high, this could mean that the stock is set to breakout of its range.

Next week we will do some research to find a real-world trade that we can track using a butterfly strategy. In the meantime, please feel free to ask me any question you would like to see covered in future articles on my forum.  


Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site

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