Now that we have discussed the basics regarding the butterfly spreads, it is time to look at variations common to many floor traders regarding positioning. As we initially saw in part A, the Butterfly Spreads are comprised of a long vertical call spread and a short vertical call spread in the same expiration on the same underlying with a common short strike. The spread is most profitable at the common short strike. The goal again is to have the stock closest to the short strike but more importantly; between the two long strikes. The same is true for put butterfly spreads. That said let us look at a variation known as the iron butterfly.

The iron butterfly is a variation comprised of a short call vertical and a short put vertical on the same underlying and done in the same expiration with a common short strike. The position would read as follows:

With BRUN @ $55 selling the May 55/60 call spread -1 55 May call/+1 May 60 call against the May 55/50 put spread -1 May 55 put/+1 May 50 put; essentially it is a delta neutral position with the goal for BRUN to be between $50 and $60 at May expiration. It is considered a variation because the goal is to have the stock trade between the short strikes. The difference in this case is the trader is looking for the stock to stay at the $55 price and take advantage of theta decay on the at-the-money (ATM) strangle. It is also considered a risk defined position in that the trader is protected by the long options on either side should the stock trade above $60 or below $50.

Many traders start out with another variation known as an iron condor which again has similar characteristics to the butterfly spread. It is done through the sale of a call vertical and a put vertical in the same expiration on the same underlying but in this variation the short strikes are set above and below the current stock price and would read as follows:

With BRUN @ $55 selling the May 60/65 call -1 May 60 call/+1 May 65 call and May 50/45 put vertical -1 May 50 put/+1 May 45 put. The spread is again risk defined in that the position is protected by the long strikes on either side. In this case the goal is slightly different then the iron butterfly in that there is room for the stock to trade up and down by $5 in either direction with the goal for BRUN to be optimally between $50 and $60 per share at May expiration. Just like with the butterfly spread, the maximum loss occurs if the stock trades above or below the long strikes. In both spreads, the sale prices are greatest with the short strikes closet to the current stock price and the narrowest distance between the longs.

The trader must choose the best spread based on the underlying fundamentals behind the underlying such as earnings, products within the pipeline, etc. Again both the above scenarios are relatively delta neutral positions and the trader is betting on stagnation to slightly nominal movement with regards to the underlying. The further out in time the trader positions themselves the greater the chance the underlying has to move over time. Let’s now look at the risk and get an idea of the differentials on the two spreads.

In the first spread, BRUN is @ $55 with approximately 28 days until May expiration. The May 55/60 call spread -1 55 May call/+1 May 60 call against the May 55/50 put spread -1 May 55 put/+1 May 50 put should sell for roughly 3.50 giving the trader a 7/3 reward to risk ratio. The trader has a break-even zone between $51.50 and $58.50 which means the trader is looking for the stock to not trade up or down 6.35% from its current price.

In the second spread, BRUN is @ $55 again with approximately 28 days until May expiration. The May 60/65 call -1 May 60 call/+1 May 65 call and May 50/45 put vertical -1 May 50 put/+1 May 45 put should sell for around 2.00 which reverses the risk reward scenario around to a 2/3 reward to risk ratio, but notice that in the case of the iron condor, the trader now has a break-even point of $47 and $63 which affords him a little more room for the stock to trade up or down. In this case BRUN can move up or down by 12.72% from its current price for the break-even and 9.09% either way closing between $50 and $60 with the position is still reaping its maximum profit potential.

The trade-off is simple and needs to be based on underlying fundamentals as well as the fundamentals of the underlying sector and factors inherent to its relevant industry. In either case, the goal is to take advantage of theta, which is greatest as options near expiration. Furthermore, the trader has the choice to repurchase the spread any time before expiration; even rolling out to the next month should he feel the fundamentals are still conducive to initiating a similar position.
 

Ross Barnett Terry, Contributor