Butterfly strategy options trading
A butterfly will break-even at expiration if the price of the underlying is equal to one of two values. The first break-even value is calculated by adding the net debit to the lowest strike price. The second break-even value is calculated by subtracting the net debit from the highest strike price. The maximum profit potential of a long butterfly is calculated by subtracting the net debit from the difference between the middle and lower strike prices.
The maximum risk is limited to the net debit paid for the position. Butterfly spreads achieve their maxim profit potential at expiration if the price of the underlying is equal to the middle strike price. The maximum loss is realized when the price of the underlying is below the lowest strike or above the highest strike at expiration. As with all advanced option strategies, butterfly spreads can be broken down into less complex components.
The long call butterfly spread has two parts, a bull call spread and a bear call spread. Please note that this is a three-legged trade, and there will be a commission charged for each leg of the trade. This profit and loss graph allows us to easily see the break-even points, maximum profit and loss potential at expiration in dollar terms.
The calculations are presented below. The two break-even points occur when the underlying equals On the graph these two points turn out to be where the profit and loss line crosses the x-axis.
A long call butterfly spread is a combination of a long call spread and a short call spread , with the spreads converging at strike price B. Ideally, you want the calls with strikes B and C to expire worthless while capturing the intrinsic value of the in-the-money call with strike A. So the risk vs. However, the odds of hitting the sweet spot are fairly low. Constructing your butterfly spread with strike B 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 strike B is higher than the stock price, this would be considered a bullish trade. If strike B is below the stock price, it would be a bearish trade.
Some investors may wish to run this strategy using index options rather than options on individual stocks. Strike prices are equidistant, and all options have the same expiration month. Typically, investors will use butterfly spreads when anticipating minimal movement on the stock within a specific time frame. For this strategy, time decay is your friend. Ideally, you want all options except the call with strike A to expire worthless with the stock precisely at strike B.
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices. If your forecast was correct and the stock price is at or around strike B, you want volatility to decrease. Your main concern is the two options you sold at strike B. A decrease in implied volatility will cause those near-the-money options to decrease in value, thereby increasing the overall value of the butterfly. In addition, you want the stock price to remain stable around strike B, and a decrease in implied volatility suggests that may be the case.
If your forecast was incorrect and the stock price is approaching or outside of strike A or C, in general you want volatility to increase, especially as expiration approaches. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike B, thereby increasing the overall value of the butterfly. Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options.
Options investors may lose the entire amount of their investment in a relatively short period of time.