Butterfly Spreads: Part C

As previously discussed, the butterfly and condor spreads are a composition of vertical spreads combined in various ways. All offer the trader various ways to profit with inherent defined risk. The long butterflies can be designed to profit as a stock moves up or down or trades sideways. The key to success is for the stock to stay in the range between the long strikes and optimally being at the common short strike nearest to expiration; which is when the spread is at its most profitable point.

Another form of the butterfly is called a double diagonal, which is a similar position to the iron condor, but is created by the long strikes being purchased in the next expiration or several expirations out and the short strikes being sold in the near-term expiration. In essence the trader is trying to take advantage of theta as well as a higher implied volatility in the near-term expiration, which may be due to general overall market volatility or possibly underlying fundamentals in the underlying such as upcoming earnings.

Let’s look at an example:

BRUN is trading @ $80.50
April weekly options have an implied volatility (IV) of 38.75% with 5 days until expiration.
May expiration options have an implied volatility 27.25% with 26 days until expiration.
June expiration options have an implied volatility 25.48% with 61 days until expiration.
The IV for the April weekly options is 11.50% over the May options and 13.25% over the June options.

A trader can buy a long strangle in June by buying the 90 calls and the 70 puts for 0.88. If he adds to the position by selling a strangle like the April weekly 87.5 calls and the 72.5 puts for 0.17 he would create a double diagonal for a 0.71 debit with 61 days until expiration for the long options and 5 days until expiration for the short options.

If BRUN stays with in the $72.50 and $87.50 range for the next 5 days the trader effectively owns the June strangle for 19.3% less then if the spread was purchased outright. It also allows the trader to reevaluate and determine if another strangle could be sold against the long strangle depending on the movement of the stock while also allowing for adjustments. In addition, the option of not selling anything against the long strangle is also left open to the trader again depending on the price of the shares at that given point in time. Each subsequent trade of course is then dependent on the movement of the shares as well as the future IV of the weekly and monthly options.

As initially stated, the reader should now begin to understand the dynamics of and the versatility with regards to butterfly spreads and their variations. They should also begin to understand that although they are slightly different, each has a similar overall goal from a strategic point of view. In addition, besides understanding the basics and grasping the concept of the butterfly and its variations. The reader should gain a better perspective of the importance of both theta and implied volatility on these spreads. The importance of these variables goes hand-in-hand when considering which strategy they feel may be the best avenue to take in the pursuit of profit.

Ross Barnett Terry, Contributor


Trader Education