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tactics essential trading strategies
SPECIAL SECTION luckbox is devoting this month’s tactics section to a special three-part series on Butterfly Spreads, courtesy of the Learn Center @tastytrade
BASIC
Butterfly Spreads
The good news is that investors can slightly tweak many option strategies, including the butterfly, to gain maximum control over the risk and reward
By Michael Rechenthin
T
he butterfly option strategy owes its popularity to its high reward-to-risk ratio, which might range from 4 to 1 to even 10 to 1. That’s risking $1 to make $4. The relatively low risk and high profit potential for the butterfly make it tempting. Who wouldn’t want to make $400 while only risking $100? The drawback is that low risk/high reward strategies generally have low probabilities of success. (See “Low, high,” right.) Take for example the butterfly trade, a trade with a low probability of success but a high theoretical return on investment. Perhaps an investor has a hunch that Schlumberger (SLB) will be at 35 by the end of the next expiration. As of mid-August, the 32.5/35/37.5 Schlumberger butterfly in October had a $50 cost and a $200 maximum profit potential. In other words, it risks $50 for a profit potential of $200. (See “Trading the butterfly,” right.) But the theoretical probability of success on the trade is slightly under 30%. Not so great. This trade has such a low probability of success because the butterfly requires that the stock remain in a relatively narrow range between its break even points, or even “pin” the short middle strike at expiration to reach its max profit. The stock has to be between $33 and $37 to make even a penny of profit; it would need to land at $35 exactly for maximum profit. Investors can slightly tweak many option strategies, including the butterfly, to gain maximum control over the risk and reward and therefore the (Continued on p. 62)
Low, high The relatively low risk and high profit potential for the butterfly makes it tempting. Who wouldn’t want to make $400 while only risking $100?
LOW PROBABILITY Reward is greater than the risk
HIGH PROBABILITY Risk is greater than the reward
Trading the butterfly The theoretical probability of success on this trade is slightly under 30%. Not so great.
september / october 2019 | luckbox
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8/29/19 2:30 PM
