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What is a Butterfly Option Trading Strategy

March 17, 2010

A long Butterfly Option Trading Strategy is a limited risk, non-directional options strategy that is designed to earn big (but limited) profits but with a low probability. The long Butterfly spread also wins when the future volatility of the underlying is expected to be lower from the current implied volatility. Just as there are several ways onf constructing a butterfly, there are may ways a trade them for both income as well as speculative/directional option trading.

Let’s start with the fundamentals of the butterfly spread (following is an example of SPX)-

  1. Buy SPY $115 Calls and
  2. Sell SPY 2x $117 Calls and
  3. Buy SPY $119 Calls

In simple terms, Sell the Body and Buy the Wings. This is a Debit spread requiring investment of $35 only. However, there is only 22.5% probability that this trade can make money.

Here is how the risk reward curve for this spread looks like. As you will notice, if someone can accurately predict underlying move, a butterfly spread can be very rewarding (In the below example, the SPY $117 call butterfly can yield over +400% if SPY is at $117 by April Expiration. Why does Butterfly spread make so much money if the underlying remains at short strike by expiration? It’s because At the Money (ATM) option has the highest time premium (aka extrinsic value) and you are selling 2 of those for each butterfly thus making it theta positive.

Butterfly Explaination

How about the greeks? Below table summarizes the Greeks, break even points as well as yield of this butterfly spread.

SPY Butterfly Greeks

It is delta neutral (at the start), Gamma negative, theta positive and vega negative. To explain it simply, the trade will make money if SPY stays within $115.36 and $118.64 by April 2010 expiration. Before expiration, assuming SPY stays at the same place, it will make money with the time decay as well as implied volatility drop.

This makes the long butterfly a good neutral option strategy for low volatility, assuming you are expecting stock price not moving much in order to collect maximum profits. It is also a low-risk strategy, since your losses are limited if the stock crashes or climbs unexpectedly. The long butterfly can also be created using all put options instead of all call options.

The key with butterfly spread is to book profit quickly and move on to the next opportunity. Don’t be greedy to book all the gains till expiration as even a single day’s large move can throw a positive trade into losing territory.

Broken wing Butterfly (BWB), ATM Butterfly, Iron Fly, Out of the Money Butterfly, 1 or 2 Skip Butterfly etc are several variations based on the similar concept. Later I shall talk about how one can use Butterfly Option Trading strategy for speculation as well as income generation.

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