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Options Trading: A Brief Discussion of Butterfly Spreads

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There are several points of emphasis regarding butterflies that are essential in order to understand their behavior.

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"I only ask to be free. The butterflies are free."
-- Charles Dickens

My last few postings have served to introduce certain families of option trades. I find it helpful to embrace the concept of various families sharing certain and specific characteristics. In doing so, it serves to help avoid the chaos of considering whether each possible option trades as its own unique individual with its own unique set of defining characteristics. Grouping these trades into families reduces the number of specific variances the trader must consider in each particular case.

While in the process of defining our families of trades and the specific cast of characters to whom we will return regularly, I want to remind readers that there will be the occasional unique trade structure that we might use to take advantage of a certain situation.

A specific example included among this cast of unusual characters is the ratio back spread. When presented with the appropriate situation, this trade construction can deliver outstanding profit opportunities with low levels of associated risk. Remember the term ratio back spread as we may look to that type of spread in order to profit from a particular scenario in the future.

For now, let us continue our study of the various families of option trades. It is the individual members of these families which we will utilize in the majority of option trades that we undertake.

Today we will begin introductions of the members of the incredibly useful family of "winged spreads." Specific members of this family include butterflies, iron butterflies, condors, and iron condors. These trade structures are built by combining vertical spreads in several specific combinations.

This family shares several important characteristics among the various individual members. These individual characteristics vary somewhat from one type of trade structure to another, but the family identity is quite clear. The similarities are best viewed in the P&L chart of a frequently used trade structure known as a call butterfly spread.


Click to enlarge

There are several points of emphasis regarding butterflies that are essential in order to understand their behavior. As regards their structure, put and call butterflies always are built from options in the ratio 1 / -2 / 1 with equal price differences in the strike prices between the central short positions and the long "wings" on either side. An example using IBM (IBM) is shown below:
Buy to Open 1 February IBM 175 Call

Sell to Open 2 February IBM 185 Calls

Buy to Open 1 February IBM 195 Call

When considered from another point of view, the trade simply consists of a vertical credit spread and a vertical debit spread which share the same short strike price.

From a functional viewpoint, maximum profit always occurs at expiration when the price of the underlying is at the short strike price. It is this relationship between the short strike and the point of maximum profit that allows the trader to express his view on price action. The short strike can easily be chosen to express a bullish, bearish, or neutral price expectation.

Another characteristic of winged structures is that these positions have a range of profitability with both an upside and downside breakeven point. The range of profitability can be adjusted by varying the width of the "wings" to establish a very tight target zone or a wide zone of profitability.

The width of the zone of profitability is correlated with the risk versus reward characteristics of the trade. The wider the zone of profitability is, the greater the risk / reward of the trade. However, the wider the profitability zone is, the greater the probability of success becomes.

An important point for traders to understand is the change in price sensitivity of the position as time goes by. Go back to the chart above and pay particular attention to the slope of the P&L graph in relation to the price of the underlying.

Note that early in its life, the butterfly responds slightly to price action and only exhibits substantial losses if price moves away from the central point of maximum profitability. However, as time passes, the butterfly becomes increasingly sensitive to price movement.

It is for this reason that most experienced butterfly traders develop a "trigger" to exit these positions as they approach the end of their life. Adverse price movements in the underlying can have significant negative effects on the P&L of the position when dealing with butterflies that are late in their expiration cycles.

There remains one major family member we need to discuss. This is the "iron condor" -- a high probability trade that can deliver profitable results in a number of market scenarios. We will review this particular trade structure next week.

Editor's Note: JW Jones offers more content at OptionsTradingSignals.com.

For more on options trading, take a 14 day FREE trial to OptionSmith. Get access to veteran options trader Steve Smith's portfolio along with emailed alerts and strategy with every trade he makes. Learn more.
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