The Option Butterfly - A High Probability, Low-Risk Options Strategy

Here's a 7-step strategy that every options trader should know. 

Step 1: The Strategy

Excessive market uncertainty and periods of high volatility can weigh down even the most seasoned options professional.  However, there is one low-stress option strategy that can give you a trading advantage in any type of market environment.

It’s known as the Low-Stress Option Butterfly Spread.

And while it may sound intimidating, the Option Butterfly is one you should know.

Why Trade Butterflies?

Unlike other options strategies such as iron condors, credit spreads, or debit spreads, butterfly options are very dynamic and can be traded for a variety of different reasons with different goals in mind, including for income.

Some benefits include:

• Delta neutral butterflies can be set up to take the guesswork out of trading.
• The Directional Butterfly Spread offers you a bullish or bearish exposure to the market while managing risk and retaining large potential returns.
• Even though butterfly spreads cannot offer unlimited profit potential, they usually cost less than buying outrights and offer an Amazing Positive Risk Reward trade set-up. 
• The Directional Butterfly can be used as a fast to execute hedge on positions that are moving against you.
• Constructing a butterfly around a strike that is under pressure from another core trade (such as a credit spread or debit spread) is a great way to control risk and lower your trading stress.
• Allows you to keep the original position open and many times that is all you need for a trade to move back in your favor.
• Long-term out-of-the-money put butterflies can also be a much cheaper method of portfolio protection than pure long puts.
• Butterflies are sometimes called “vacation trades” due to their low risk and need for only very infrequent monitoring.
• Butterfly trades are generally very slow moving early on in the trade.

Step 2. The Option Greeks You Need to Know

The "Greeks" provide a way to measure the sensitivity of an option's price to quantifiable factors.

They are strictly theoretical, meaning the values are projected based on mathematical models.     

A Brief Review of the Greeks

• Theta – (decay movement) measures your time decay (per day) – increases each day as it gets nearer EXP. & at zero at EXP.
• Implied Volatility – (price movement) what the marketplace is “implying” the volatility of a stock will be in the future & its effect on where price will be
• Delta – (price movement) measures the change per $1 change in the underlying & a measure of price probability
• Vega – (volatility movement) measures the change per 1% change in volatility, decreases each day & at zero at EXP.
• Gamma – (price movement) is the rate of acceleration of delta based on a $1 change in the underlying – most at risk & largest impact last week of EXP.

 

Step 3.  The Most Important Option Factor

The most important option factor for profit generation using the Butterfly Strategy comes down to understanding the concept of TIME, and its effect on the price of an option…

Time Value is used for trading strategies that take advantage of the accelerated Time Decay of an option into its Expiration. Butterfly Strategies are very tied to Time Value (Theta) & the impact it has on the price of an option.

What exactly is Time Value?

Time value (TV) (extrinsic) of an option is the premium a rational investor would pay over its current exercise value (intrinsic value), based on its potential to increase in value before expiring. This probability is always greater than zero, thus an option is always worth more than its current exercise value. The change in the value of an option, based on Time Decay, can be measured using Theta…

Option Theta

Theta tells you how much an option's price will diminish over time, which is the rate of time decay of a stock’s option. Time decay occurs because the extrinsic value, or the Time Value, of options diminishes as expiration draws nearer.

By expiration, options have no extrinsic value and all Out Of The Money (OTM) Option expire worthless. The rate of this daily decay all the way up to its expiration is estimated by the Options Theta value. Understanding Option Theta is extremely important for the application of option strategies that seeks to profit from time decay.

Options Theta - Characteristics

• Option Theta values are either positive or negative.
• All long stock option positions have negative Theta values, which indicates that they lose value as expiration draws nearer.
• All short stock option positions have positive Theta values, which indicates that the position is gaining value as expiration draws nearer.

For Example:

An option contract with Option Theta of -0.10 will lose $10 per contract every day even on weekends and market holidays. The buyer/holder of an option contract over a 3 day long weekend with a price of $1.40 or $140 per option contract and an option theta of -.10 will find the price of that option at $110 instead of $140 after the 3 day weekend.

Theta Decay Strikes!

• Option theta does not remain stagnant.
• It increases as expiration draws nearer and decreases as the options go more and more In-The-Money or Out-of-The Money.
• In fact, the effects of time decay are most pronounced during the final 30 days to expiration where theta soars.

Take a look at the following chart to see just how predictable and powerful this option paradigm is!

Step 4. How Option Pricing Works

How to value an option

Time Value (x) Implied Volatility (x) Intrinsic/Extrinsic Value

Note: Once you know these variables then you are ready to price an option & know what its option premium should be.

Step 5. The Butterfly Foundation - Vertical Spreads

Butterfly Foundation: Vertical Debit & Vertical Credit Spread

Vertical Debit Spread:

• A "bull call" spread, entails buying one call and selling a higher-strike call, that will be lower in price to offset some of the premium cost & theta decay
• A “bear put” spread entails buying one put and selling a lower strike put, that will be lower in price to offset some of the premium cost & theta decay
• These spreads are done for a debit

Vertical Credit Spread:

• A “bear call" spread, entails selling one call and buying a higher-strike call, that will be higher in price to hedge the short call. Premium collection.
• A “bull put” spread entails selling one put and buying a lower strike put that will be lower in price to hedge the short put. Premium collection.
• These spreads are done for a credit

Step 6. Selecting the Right Butterfly Option Strategy

One major goal of every trader should be to select trades based on what provides the most consistent positive return with low, defined risk, not always the greatest return. And one of the best ways to achieve this is by knowing the Option Butterfly Strategies that are available, how they work and then selecting the one that is best suited for the market environment you are trading.

Butterfly Strategies

• Long Call or Put Butterfly
• Short Call or Put Butterfly
• Broken Wing Call or Put Butterfly
• Unbalanced-Ratio Butterfly
• Directional Butterfly
• Iron Butterfly
• Hedging – Defenses Using Butterflies

Step 7. Favorite Butterfly Trades & Hedging

• Long Call or Put Butterfly

Long Butterfly Option Spread (Call or Put)

• It’s a combination of a bull call debit spread and a bear call credit spread
• It is a limited profit, limited risk options strategy
• 3 striking prices involved in a butterfly spread and it can be constructed using calls or puts
• Called a butterfly spread because you are short the body & long the wings
• Can be used as a neutral or directional option trading strategy
• Trade results in a small net debit & max risk is the debit paid
• Due to small net debit this strategy offers a great risk-to-reward
• Short Volatility & Theta strategy
• A target price pinning strategy

Max Profit

The maximum profit occurs should the underlying stock be at the middle strike or body at expiration. In that case, the long call with the lower strike would be in-the-money and all the other options would expire worthless. The profit would be the difference between the lower and middle strike (the wing and the body), less the premium paid for initiating the position, if any.

Max Loss

The maximum loss occurs when the underlying stock ends up outside the wings at expiration. If the stock were below the lower strike all the options would expire worthless. If above the upper strike all the options would be exercised and offset each other for a zero profit. In either case the premium paid to initiate the position would be lost.

Butterfly Spread Example:

Assuming xyz trading at $43.57.

Buy to Open 1 contract of June $42 Call at $2.38

Sell to Open (2) contracts of June $43 Call at $1.63.
Buy to Open 1 contract of June $44 Call at $1.06

Net Debit = ($2.38 + $1.06) - (2x $1.63) x 100 = $18.00 per position

Profit Calculation of Butterfly Spread:

Maximum Profit = (Middle Strike - Lower Strike - Net Debit) x 100

Assuming xyz closed at $43 at expiration.

Maximum Profit = $43 - $42 - $0.18 = $0.82 x 100 = $82.00

ROC = $82/$18 = 455%

Unbalanced Butterfly or Ratio Butterfly

This is another variation of the regular, equal strike, butterfly but adds an additional short vertical credit spread. It’s simply 2 out-of-the-money credit spread, protected by a slightly narrower, closer to the money debit spread. This is for the more aggressive trader. Like the Broken Wing Butterfly Spread, it alters the risk to one direction & increases the potential reward. It increases the income potential, but also increases the risk.

Butterfly Hedge Defense             

• A Defensive Hedging Strategy for Vertical Debit & Credit Spreads
• Hedging Foundation Based on using an offsetting Vertical Spread

Butterfly Foundation: Vertical Debit & Vertical Credit Spread

Vertical Debit Spreads:

• A "bull call" debit spread buying one call and selling a higher-strike call that will be lower in price to offset some of the premium cost.

• A “bear put” debit spread buying one put and selling a lower strike put that will be lower in price to offset some of the premium cost.

These spreads are done for a debit

Vertical Credit Spread:

• A “bear call" credit spread selling one call and buying a higher-strike call that will be higher in price to hedge the short call. Premium collection.

• A “bull put” credit spread selling one put and buying a lower strike put, that will be lower in price to hedge the short put. Premium collection.                                   

            These spreads are done for a credit

Example TSLA:

Original Call Debit Spread

Price Trading at $250

• Buy Dec $245 strike call for $15.00 
• Sell Dec $255 call for $10.00

Spread width: $10.00

Debit Spread: $5.00 or $500/contract

Max Reward: $500

Max Loss: $500

ROI: $500/$500 = 100%

Convert to a Long Call Butterfly:

TSLA trading off, worried it may stall but still want to hold for the move higher but decide to reduce the potential risk of a $500 loss.

1. Original Trade – Vertical Call Debit Spread- (Price Trading at $250)

Buy 1 Dec $245 call for $15.00 

Sell 1 Dec $255 call for $10.00

Debit: $500 = 1:1 R:R

2. Convert to Long Call Butterfly – Sell Vertical Call Credit Spread.

    (Now Price Trading at $245)

Sell 1 Dec $255 for $8.00

Buy 1 Dec $265 for $5.00

3. New Long Call Butterfly:

Long 1 Dec $245 call $15 (debit)

Short 2 Dec $255 calls ($10 + $8) = $18 credit

Long 1 Dec $265 call $5 (debit)

New Long Call Butterfly:

Long 1 Dec $265 call $5 (debit)

Short 2 Dec $255 calls ($10 + $8) = $18 credit

Long 1 Dec $245 call $15 (debit)

Max Risk: Net Debit:

Dec $245 debit $15 + Dec $265 debit $5 = Total debit $20

Short 2 Dec $255 calls total credit $18

Max Debit: $20 debit - $18 credit = $2.00 or $200/contract vs $500/contract

Max Reward: Difference in Strikes – net debit

                           $1000 - $200 = Max Reward $800

Risk:Reward = Positive $800/$200 = 4:1 versus 1:1 on Original Spread

ROI: 400% if at $255 at expiration