Butterfly series, part 1: long butterfly spread
What's a long butterfly?
A butterfly is three legged ratio strategy; we'll be starting with long butterfly spreads with calls below. Butterflies have a very enticing profit and loss graph at expiration: the graph shows very little downside risk relative to the upside potential. When you buy a butterfly, it's usually entered all as one trade from the TradeKing butterfly trade screen and often the butterfly view in the option chain page is the starting point to enter the trade.
A long butterfly spread with calls is a combination of a long call spread and a short call spread, with the spreads converging at the middle strike price - in this example, we're talking about a stock trading currently at 42.50. Ideally, you want the calls with the 42.50 and 45 strikes to expire worthless, while you capture the maximum intrinsic value of the in-the-money call with the 40 strike. In theory this can only occur if the stock closes at expiration just below the middle strike (42.50). NOTE: Strike prices are equidistant, and all options have the same expiration month.
Because you're selling the two at-the-money options with the middle strike (42.50), butterflies are a relatively low-cost strategy. So the risk vs. reward can be tempting. However, the odds of hitting the sweet spot are fairly low.
Constructing your butterfly spread with the middle strike (42.50) slightly in-the-money or slightly out-of-the-money may make it a bit less expensive to run. This will put a directional bias on the trade. If the middle strike is higher than the current stock price, this would be considered a bullish trade. If middle strike is below the current stock price, it would be a bearish trade. (But for simplicity's sake, if bearish, puts would usually be used to construct the spread).
As expiration nears...
Let's work through an example and talk about the butterfly and how it gains in value as expiration approaches.
We put on this butterfly with the stock exactly at the strike, 42.50 buying one 40 call, selling two 42.50 calls and buying one 45.00 call; all of these calls have 45 days to expiration. So we have a neutral outlook on the stock since the middle strike is equal to the current stock price.
If we fast-forward to expiration (45 days form today), and our forecast is correct and the stock finishes at 42.50, the theoretical max profit of 2.15 may be achieved. The max profit is the difference between the strikes or 2.50 (42.50 - 40) minus the debit paid (.35) for the trade. So the max profit for the trade is 2.15 (2.50 - .35) or $215 (100 x 2.15) less commissions for each 1x2x1 butterfly executed. If you like pictures better than words the profit and loss graph may illustrate this more clearly.
If this scenario comes to pass the rate of return on the trade is astronomical. You are risking .35 with the potential to make 2.15 - that's over a 600% (2.15/.35) rate of return. Now before you start thinking this is the ultimate option strategy, think about the likelihood of this happening. The stock would have to finish at the strike price on the expiration date. If it gets there anytime before expiration the maximum profit will not be achieved. Don't forget, too, that you can lose your entire investment if the stock finishes below 40 or above 45. So all of this begs the question: how does the profitability of the butterfly work as expiration approaches?
To answer this question we need another graph. Let's assume we're dead on with our forecast, and the stock stays at 42.50 for the entire length of the trade all the way to the expiration date. So this graph is a theoretical option pricing calculator of sorts, showing us the value of the butterfly throughout time. You'll notice in the graph the X-axis is titled "Days to Expiration" and the Y-Axis is titled "Butterfly Value". If we put on the butterfly today, day 45 (until expiration), the graph shows that we paid $35 for it. If 17 days go by and we are now on day 28, according to the graph the butterfly would now be worth $40 -- that's only a $5 increase. If 31 days go by and it's now day 14, the butterfly would be worth 50 - not a bad gain on a percentage basis, $15 (50 - 35) on a $35 investment. Then again, this is nowhere close to the max profit.
As we can see in the graph it's only in the last week to expiration that the butterfly really starts to gain in value. So now many of you might think: okay, so I'll do the trade on day 7 then, if that's when the money really hits - but the tradeoff is a big increase in initial cost. At day 7 the same trade yields more, but now it costs you $59 vs $35 (70% more). What's more, the stakes are substantially higher, too: if the stock does start moving away from the strike, since we're so close to expiration the losses will pile up quickly. (my post on the Greek gamma will make this concept a little clearer). Many traders who trade butterflies as a standalone strategy do many of them at once (not just a one lot) and play the position in its earlier stages. When the percentage gain starts to look good (e.g. buy on day 45, sell on day 21), they'll get out of the trade and not wait for the homerun at expiration. That is, they choose not to take the risk of losing all the gains in the last week in a fairly unlikely hope that the stock will finish bang-on at the strike.
Many, many uses for butterflies...
Traders use butterflies for almost the full gamut of trading possibilities: for speculation, as described above, for hedging, for volatility plays, even as a rolling feature to help recover from a trade gone bad. Next week we'll move to another speculative variation, the split-strike butterfly, and then progress through the various types until we've covered all these angles. As you can see, butterflies pack a lot of variety into one general trade type. We'll explore benefits and risks to each type of butterfly as this series progresses.
Until next week, then!
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
Edited by optionsguy at 09/03/11 at 07:16 AM