In this discussion, butterfly spreads and variations will be addressed in an attempt to build on a concept that will be further explained in additional soon-to-be released articles. The trader should then have a fundamental grasp on the different ways to properly position themselves for a wide array of scenarios in regards to the underlying security in question.

Butterfly spreads are an options position created by buying one vertical spread and selling another with the short strike of the verticals being identical. Usually either all calls or all puts are used. Butterflies are away to target a stock price regarding a specific range and time and are considered to be relatively low risk plays. In essence the short vertical, or vertical that is sold, is used to pay for apart of the cost of the long vertical, or vertical you purchase. They are generally considered low risk because the cost is defined.

Here’s an example:

BRUN trading @ $55

The long May 60/65/70 call butterfly trades for 0.50 with 3 to 4 weeks left until expiration at a nominal implied volatility of say 30 – 40 percent.

The position would read as long 1 May 60 call, short 2 May 65 calls and long 1 May 70 call.

The most a trader can lose would be $0.50 not including commissions. The potential for profit is 9 to 1 in that, if at expiration, BRUN were to trade at $65 the spread would be worth $4.50 (difference in the bought and sold strikes (5) minus the cost (.50)). A similar spread could be created through the use of put options with the May 50/45/40 strikes. The call butterfly would be considered bullish and the put butterfly bearish. Buying both creates a position that profits from a move either way, optimally of about 18% up or down. Since maximum profit is earned at expiration, ideally a trader wants to stay within a couple months of expiration due to the nature of options in regards to time decay (theta).

In addition to moving further out the strikes of a butterfly spread can be widened out to create a larger “target area”. Using the example above, a spread can be constructed as such; long May 60/70/80 call butterfly. The position would read as long 1 May 60 call, short 2 May 70 calls and long 1 May 80 call. This raises the maximum profit target to $70 and increases the potential reward to $10.00 minus the cost from the initial optimal reward of 5.00 minus the cost. The same could be done on the put side especially if there is an expected move down lower in the stock.
The most important factors in contemplating butterflies are timing and price regarding the initial costs. Evaluating the sales and revenue streams as well as sector rotation is just as important from a fundamental perspective as well as the timing with regards earnings cycles.

With the basics of butterfly spreads understood, even the most novice trader can begin to grasp the benefits and the potential risk/reward butterflies can bring especially when taken from a stance that they can be constructed by initiating the vertical spreads on either or both sides. A long vertical call spread can easily be rolled into a butterfly spread by selling a call spread. The spreads can be placed on individual stocks, ETF’s, indices, and futures alike.
 

Ross Barnett Terry, Contributor