Tactics: Butterfly Spreads Series

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

The 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.

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 diagram below.) 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.

Trading the butterfly

The theoretical probability of success on this trade is slightly under 30%. Not so great.

Investors can slightly tweak many option strategies, including the butterfly, to gain maximum control over the risk and reward and therefore the probability of success. Depending upon the objective, one trade might be ideal for the particular circumstance.

For the butterfly to have a considerably higher probability of success, investors can unbalance it. (See the Advanced article in this series) That makes the “profit zone” much higher. Instead of pinpointing a strike, the butterfly can be modified to make it profitable at “any price above X or price below X.” Going back to the Schlumberger example, the strikes can be modified to create the 30/35/37.5 unbalanced butterfly with considerably greater risk (in the example below it is $230) but with a considerably greater probability of success— roughly 60%. Here, instead of a relatively small “profit zone” and a 4-to-1 reward-to-risk ratio, the “profit zone” is much wider, and the reward-to-risk is a more modest 1-to-1.

Unbalanced butterfly

Instead of pinpointing a strike, the butterfly can be modified to make it profitable at any price above X or price below X.

Which is better: “regular” butterfly or unbalanced? In practice, neither. It’s all about using either to find one’s preferred balance between risk, reward and probability of success.

Michael Rechenthin, Ph.D., (aka “Dr. Data”) is head of research and data science at tastytrade.

INTERMEDIATE

The Butterfly Payoff

What’s the right environment for the butterfly spread?

By Anton Kulikov

While short straddles and strangles are great trades when investors want to speculate that a stock will not move much, the risk can seem too great. The long butterfly provides a potential alternative.

A butterfly spread has low probability and low risk. That means there’s a low probability of profit but also a low probability of large losses. For that reason, traders can use the strategy when they’re feeling speculative. Even when the butterfly loses money, it typically doesn’t lose big. Because losses will be minimized, it will be cheaper to execute.

But exactly how does this strategy work? And what’s the right environment for the butterfly spread?

An investor who speculates that a stock won’t move very much from its current price can create a butterfly spread by buying one in-the-money option (ITM), selling two at-the-money options (ATM) and buying one out-of-the-money option (OTM).

This leads to paying a debit when opening the trade, which will affect max profit. Overall, the strategy has a neutral assumption, meaning the investor expects the price of the underlying stock to remain fairly close to its current price.

Also, investors typically use butterfly spreads in high implied-volatility environments, which makes butterflies cheaper. Keep the trade as cheap as possible to avoid tying up too much capital and to minimize potential losses.

Next, look at the math behind the risk and reward of the strategy. (See “Payoff diagram,” below.)

Payoff diagram

A quick way to calculate max profit is to take the width of the butterfly ($5) and subtract the debit paid/max loss of the spread ($0.50)

In the payoff diagram, a butterfly is long one 45 call, short two 50 calls and long one 55 call. It’s a $5 wide butterfly strategy, meaning that the long ITM and OTM strikes are $5 away from the two short ATM options. Say an investor pays a $0.50 debit for this 45/50/500 call butterfly, and assume the stock is at $50. This butterfly has its max profit of $450 when the stock is trading at $50 at expiration and a $50 max loss if the stock is either below $45 or above $55 at expiration. Breakevens for this strategy are $45.50 on the downside and $54.50 on the upside. A quick way to calculate max profit is to take the width of the butterfly ($5) and subtract the debit paid/max loss of the spread ($0.50). In the case of butterflies, the amount an investor pays for it always equals its max potential loss.

This butterfly profits when the underlying price remains between the $45.50 and $54.50 breakeven points, so an investor would want the underlying price to remain fairly close to its current $50 price. Yet even if the underlying price moves outside the breakeven points, it only tests one side, so the maximum loss is that initial debit paid.

Finally, the reason investors want to place this spread in high implied-volatility environments is that the debit paid and max loss will be minimized and max potential profit maximized. Ideally, investors use this strategy when they do not have a directional assumption about the underlying. Because this strategy has positive theta, the ideal scenario is for the stock to stay as close to the ATM short strikes as possible. If that happens, investors realize full max potential profit at expiration. Additionally, profits throughout the trade can accelerate if the implied volatility environment of the underlying drops. That causes the value of the short options to go down more than the value of the long options, thus resulting in a net gain for the overall position.

So, if the implied volatility is high and an investor doesn’t expect the stock price to move much, this strategy could be in the toolbox. But investors should make sure to consider their motives, the current environment and the risk/reward associated with each trade when choosing a strategy.

Anton Kulikov is a trader, data scientist and research analyst at tastytrade.

ADVANCED

The (Broken Wing) Butterfly Effect

Trading a BWB at price extremes affords the trader room for the trend to continue and zero risk, if the trend reverses

By Michael Gough

When markets reach price extremes, either higher or lower, what’s the best move— trade the trend or risk the reversal? If markets are truly memoryless, then either choice may be a 50-50 shot.

But using options can improve those odds and reduce the emphasis on having the right directional opinion. The question is really which strategy should a trader choose: strangles, credit spreads or naked? But that’s an incomplete list. For a high-probability trade for a market extreme, there’s also the brokenwing butterfly (BWB).

Before trading a BWB, traders should familiarize themselves with the structure of a traditional butterfly spread. (For a primer, see this series’ Intermediate article, p. 60.) Like the traditional butterfly, BWBs are comprised of either all calls or all puts. But the difference is a BWB has a “broken” wing.

For example, a traditional butterfly has equal width wings (e.g., 95-100-105 strikes), while a BWB has unequal width wings (e.g., 95-100-107 strikes). Breaking the wing can turn the trade from a debit spread to a credit spread. BWBs should always be traded for a credit. This slight alteration drastically improves both the probability of profit and potential max profit of the trade.

To place a BWB, look for an underlying with high implied volatility at a recent price extreme. At the time of this writing, one such underlying is gold. Recent fears of economic uncertainty sent investors flocking to buy gold, which drove up both the price and implied volatility. Prices in this example are for gold futures (commonly denoted “/GC” on brokerage platforms), but a similar trade can be placed on the GLD ETF (An exchange-traded fund for gold) for lower capital requirements.

Traders who are bullish on gold and think the upward trend will continue may consider a call BWB (a contrarian who’s bearish could trade a put BWB). With the underlying at $1,423, a bullish BWB could be the 1445-1455-1475. That’s buying one 1445 call, selling two 1455 calls, and buying one 1475 call for a $1.60 credit. The trade has a max profit of $10.95 and, according to the Tastyworks platform, a 74% probability of making a profit! Because the trade is placed for a credit, the investor takes zero risk to the downside. If gold sits at $1,455 on expiration day the trade will make the max profit of $10.95. If gold reverses direction, the trade still makes $1.60!

Compare that to a traditional butterfly. The 1445-1455-1465 traditional butterfly requires a $0.40 debit to trade and has a max profit of only $9.60 with a 15% probability of making a profit. Breaking the wing drastically alters the performance characteristics of the trade. The differences in potential profits and losses between these two butterfly spreads is depicted in “Broken wing” below.

Broken wing

The difference in potential profits and losses between these two butterfly spreads are depicted here. The green shows the traditional butterfly, and the purple shows a broken-wing butterfly.

Note, however, that the increased potential max profit and probability of profit aren’t free; trading is all about risk and return. With its improved risk/return profile, the BWB also has greater risk. The potential max loss of the BWB is $8.40 (width of the wider spread minus the credit received) while the potential max loss of the traditional butterfly is only $0.40 (debit paid to enter the trade).

Trading a BWB at price extremes affords the trader room for the trend to continue and zero risk, if the trend reverses. In this example, if gold continues its rally to the body of the butterfly (short options), the trader would collect max profit. On the other hand, if gold reverses its direction the trader simply keeps the credit received to place the trade. Both butterflies would lose money if gold continues to rally beyond the further out-of-the-money call. As a way to trade the trend or fade a move, consider the broken wing butterfly.

Michael Gough, a self-taught coder who became an options trader, is on the futures product development team at The Small Exchange.