Butterfly Option Strategy: The Definitive Guide [2019]

Butterfly Option Strategy: The Definitive Guide [2019]

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Butterfly Option Strategy

Today you’re going to learn the exact steps for the butterfly option strategy.

In fact:

What I’m going to reveal to you in this guide is the same options trading criteria I used for each of my butterfly options trades.

On top of that, this guide will teach you all the different variations of the butterfly option strategy that may be a good fit for your options trading tool box.

Let’s get into it.

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1

The Butterfly Option Strategy Setup

In this chapter, you’ll learn the basics of the butterfly option strategy.

 

Specifically, I’ll show you how to construct the butterfly strategy including the trading criteria I use.


(Including lots of real life examples of this strategy in action)

Build The Butterfly Option Strategy

A long butterfly option spread is a neutral strategy that benefits in the non-movement of the underlying stock price.

Here’s how it works:

The butterfly option strategy is made up of a long vertical spread and a short vertical spread with the short strikes of the two spreads converging at the same strike price.

Here’s the exact setup:

  • Buy one call/put above the short strike
  • Sell two calls/puts (typically at-the-money)
  • Buy one call/put below the short strike

The result?

Two vertical option spreads with the same short strike.

Butterfly Spread With Puts

Not sure if you noticed, but you can set up a butterfly spread with either puts or calls. 

Let’s take a deeper look at how to construct the butterfly spread with put options.

Here’s the setup:

  • Buy one put above the short strike
  • Sell two puts (typically at-the-money)
  • Buy one put below the short strike

It’s pretty much the same set, except you are using only put options.

Like all butterfly spreads, this strategy relies on non-movement in the underlying price, time decay and a decrease in implied volatility.

I’ll get into the detailed trading criteria in the next chapter.

Butterfly Spread With Calls

You can also set up a butterfly spread with call options.

Here’s how that looks:

  • But one call above the short strike
  • Sell two calls (typically at-the-money)
  • Buy one call below the short strike

Starting to see a pattern?

Butterfly Spread With Calls Versus Butterfly Spread with Puts

So, what’s the difference between butterfly spreads with calls and butterfly spreads with puts?

There actually is not really much of a different.

They are synthetically the same exact trade.

The only reason you may want to pick one over the other is if you are skewing the strategy to one side or another.

Let me explain.

Let’s say you are slightly bullish on the stock price, so you want to skew your butterfly spread above the current stock price.

This situates your “home-run” profit zone above the current stock price.

In this case, you’d probably want to use call options, since they will be out-of-the-money at the time you initiate the trade.

Remember:

You generally want to trade out-of-the-money options because that’s where the liquidity is and that’s the mechanical thing to do.

Likewise, if you are bearish on the stock price, you would want to skew the butterfly spread to the downside.

In this case, it’s best to use put options for your butterfly spread.

2

The Butterfly Option Strategy Trading Criteria

Now that you understand how to build the butterfly option spread, now it’s time to understand the details.


When is this strategy best used? What’s the maximum profit on the butterfly spread? What’s the break even point?


These are all questions that I will answer in this chapter.


Let’s dive in.

When To Use The Butterfly Option Strategy?

The butterfly option strategy is best used when you think the stock price is not going to move very much.

This is because the butterfly strategy needs to stay as close to the short strike as possible as time decay goes on.

Ideally, you want to capture all the extrinsic value of the two options that you sold, while the in-the-money maintains its intrinsic value.

Ideal Implied Volatility Environment 

The butterfly option strategy is best used in high implied volatility environments. 

When implied volatility is high, you can sell options for a higher price.

This makes butterfly spreads trade cheap in high implied volatility environments.

Remember:

When you are paying for something, you always want to pay less for it.

You profit if the stock price doesn’t move and if implied volatility decreases.

Implied Volatility Definition

Implied volatility is a measure of how expensive the price of an option is. Implied volatility is determined by market participants who are betting on the future price range of a stock price.

Calculating The Maximum Profit For the Butterfly Strategy

Here’s how you calculate the maximum profit:

You take the width of one of the vertical spreads minus the net debit paid.

Here’s an example:

You buy the $48 strike put, sell two of the $50 strike puts, and buy one $52 strike put. You buy this package for a total of $0.50.

Since the difference between $48 and $50 is $2, that’s the width of the spread.

Then, you have to subtract what you paid for the butterfly, which is $0.50.

This leaves your maximum profit at a total of $1.50.

Calculating The Maximum Loss For The Butterfly Strategy

Calculating the maximum loss for the butterfly spread is very simple and actually does not require any calculation.

That’s because the maximum loss is only what you paid for the butterfly.

So, continuing with the previous example, your maximum loss on the spread would be $0.50.

Because this is a defined risk options trading strategy, there is no margin required for this trade.

Calculating Your Break Even Prices For The Butterfly Strategy

There are two break even points for the butterfly spread.

One to the upside and one to the downside.

Here’s how to calculate those break even points:

  • Take the strike price of the lower option that you bought plus the debit paid for the spread.
  • Take the strike price of the higher option that you bought minus the debit paid for the spread.

Quick Tip

Most good options trading brokerage platform will automatically calculate your maximum profit, maximum loss and break even prices for the butterfly option strategy, so you won't have to calculate these numbers yourself. 

When Do You Close Butterfly Spreads?

On paper, butterfly option spreads have a very high profit potential. 

However, the probability of actually pinning the stock price right at your strike price is very small.

So, as a rule of thumb, you should make your profit target 25% of the maximum profit.

Here’s how that works:

You buy the $48 strike put, sell two of the $50 strike puts, and buy one $52 strike put. You buy this package for a total of $0.50.

Your maximum profit on the trade is $1.50. And 25% of that is $0.375.

So, you should close the trade when you reach a profit of $37.

What To Do With Losing Butterfly Spreads?

Since butterfly option strategy is a defined risk position, losses are not managed.

Instead, you should let the probabilities play out on the trade and take the loss if needed.

3

Butterfly Option Spread Example

You spread know the fundamentals of the butterfly trading strategy in a conceptual way.


But let’s talk numbers.

 

In this chapter, I’ll show you a detailed example of the butterfly spread.

Butterfly Example

Let’s say you buy the $45, $50, $55 call butterfly for $1.85 debit.

Maximum Profit

Your maximum profit on this call butterfly is $3.15.

Take the width of the spread minus the debit paid.

So, $5.00 minus $1.85.

Maximum Loss

Your maximum loss on the butterfly is what you paid for it.

Aka $1.85.

Break Even Points

You have two break even points for the butterfly strategy.

The first break even point is $46.85 and the second is $53.15.

To calculate the first break even, take the lower strike, $45, and add the debit paid ($1.85).

To calculate the second break even, take the upper strike $55, and subtract the debit paid.

You can execute the same exact trade using put options.

It wouldn’t make any bit of difference.

4

The Iron Butterfly Option Strategy

To this point, I’ve only discussed the butterfly spread.

 

But there is another options strategy that is very similar.


The iron butterfly.


Let me explain.

The Iron Butterfly Option Strategy

The close cousin of the butterfly spread is the iron butterfly.

What’s the difference between the regular butterfly and the iron butterfly?

The main difference lies in the composition of options contracts you use to construct the butterfly spread.

Remember:

The regular butterfly spread either used all call options or all put options.

The iron butterfly option strategy used both call options and put options.

Here’s how that works:

  • Buy one lower strike put option
  • Sell one put option and one call option at the same strike (typically at-the-money)
  • Buy one higher strike call option.

Here’s how that looks on the profit and loss diagram.

The profit and loss diagram looks pretty much identical to the one where traded the butterfly with puts and the butterfly with calls. 

The same exact trading criteria apply for the regular butterfly spread as the iron butterfly.

So, why trade one version of the butterfly strategy over the other?

It all comes down to our trading mechanics.

See, I never like to sell in-the-money options. It’s just not the mechanical thing to do when trading options contracts.

If you ever want to skew the strategy to one side or another it’s best to use the regular butterfly spread because you can construct that trade with all out-of-the-money options.

However, if you center your trade at-the-money, then you can use the iron butterfly because you are selling at-the-money options, not in-the-money options.

Quick Tip: Iron Butterflies

Whenever you see the word "iron" in the name of any options trading strategy, it typically means that you are using both call and put options to construct the trade. Some examples are iron butterflies and iron condors. 

5

The Broken Wing Butterfly

In this chapter, I’ll show you the details of another variation on the butterfly spread.


In my opinion, the broken wing butterfly is a must have for your options trading toolbox.


Seriously.


And in this chapter, you’ll learn how to use the broken wing butterfly that have over a 80% probability of success.

To this point in this guide about the butterfly spread, I’ve only showed you the standard butterfly.

If you’ve ever taken a look at the risk-to-reward ratio on a butterfly spread, it looks phenomenal.

The problem with the standard butterfly spread is that it is typically a low probability trade, meaning it is really hard to make consistent profits with the butterfly spread.

Instead, the broken wing butterfly spread is high-probability strategy.

Here’s how this strategy works with call options:

  • Buy one lower strike call option
  • Sell two out-of-the-money call options at the same strike
  • Skip a strike and buy one higher strike call option

And here’s the strategy with put options:

  • Buy one higher strike put option
  • Sell two out-of-the-money put options at the same strike
  • Skip a strike and buy one lower strike put option

Here’s what that looks like on a profit and loss diagram.

So, what have we effectively done here?

First, you can think of a butterfly as two vertical spreads: one credit spread and one debit spread that converge at the same short strike.

By skipping a strike on the credit spread, we have created a larger credit spread than the debit spread.

This means you are collecting more option premium with the credit spread than you are paying in premium for the debit spread.

The result?

Absolutely no risk to one side of the trade (where a regular butterfly spread had risk to both sides).

This is what makes the broken wing butterfly strategy so powerful.

As long as the underlying price stays away from your break even price, you are profitable, though your home-run on the strategy is if the stock price pins your short strikes.

As far as trading criteria, it follows in line with the regular butterfly spread and the iron butterfly.

Broken Wing Butterfly Example

Let’s walk through a detailed example of the broken wing butterfly with numbers.

Let’s say the current stock price is $100 and you are bullish on the stock price.

  • Buy one $99 strike put 
  • Sell two $98 strike put
  • Buy one $96 strike put

You take the package for a net credit of $0.25.

Here’s what that looks like on the profit and loss diagram.

Now It's Your Turn

So, those are my best tips, strategies and secrets for the butterfly option strategy.

 

Now I’d like to hear from you:


Which variation of the butterfly option strategy are you going to try first?


Are you going to use the butterfly with puts? Or maybe you want the higher probability of success with the broken wing butterfly.


Either way, let me know by leaving me a comment below right now.

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