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Options Trading: A Brief Discussion of Butterflies, Part 2

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The call butterfly was introduced last week. The closely related put butterfly has very similar characteristics.

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Editor's note: Click here to read Part 1.

The discussions last week served to introduce the family of the "winged" trade structures. This family includes a number of members and is notable for its range of price of the underlying. Essentially, if the price of the underlying stays within the profitability range at expiration a butterfly produces a profitable trade. The various members include the call butterfly, the put butterfly, the iron butterfly, and the iron condor.

I thought it would be helpful to discuss some nuances of the behavior of these classic butterflies before we proceeded to a discussion of their ferric relatives. This particular group of trades has some important operational characteristics that are not immediately apparent and therefore deserve particular emphasis.

We introduced the call butterfly last week. The closely related put butterfly has very similar characteristics. The choice in a particular trade between a put and call butterfly turns on the expected price move of the underlying.

These trades are constructed using three different strike prices within the same expiration series of options. The classic ratio for constructing each butterfly is 1 / -2 / 1. Remember that the maximum profit is achieved at expiration when the price of the underlying is at the strike price of the short options forming the center of the butterfly.

In order to avoid the unpleasant surprise of early assignment of the options you are short, it is usually best to initiate the trade using the current out-of-the-money strike for the target price. This means for a bullish price hypothesis we would use out-of-the-money calls as the center price and for a bearish price hypothesis we would choose out-of-the-money puts.

This sounds really confusing. Let us consider a specific example in order to see how simple it is in practice. Consider the case of Apple (AAPL) with a current market price of $420 / share as I write.

A trader with a bullish expectation will be best served by using calls with strike prices above $420 for the central short strike. A bearishly inclined options trader would use puts with strike prices below $420 to build the central "body" of his butterfly.

The resulting trades can be easily visualized in their P&L graphs embedded below.


Click to enlarge

Important to recognize here is the outstanding risk / reward characteristic of each curve. In both cases the trader is rewarded on the order of $5 for each $1 risk in a correctly structured trade.

Let me be the first to point out that traders seeking high probability opportunities will rarely fully realize the full profit potential of this trade. As the butterflies approach maturity, they become increasingly sensitive to minor fluctuations in price of the underlying.

Successful butterfly traders recognize this peculiarity and routinely close butterfly trades prior to their final days of life when reasonable profitability targets have been achieved.

Another important characteristic of these trades is the time sequence for delivering profits. These trade structures do not typically respond strongly to price movements until they reach only a few weeks until expiration.

This is a double edged sword; trades resulting from incorrect price hypotheses can often be terminated with minimal loss early in the life of the butterfly. Conversely, the trader who is "spot on" with his price prediction will often be rewarded with minimal profits if his scenario is realized too quickly.

I think it is vitally important for traders new to the world of options to understand the extremely dynamic nature of the risk / reward characteristics presented by options.

Many option trades exhibit extreme fluidity in their risk / reward curves with regard to not only price of the underlying but also time to expiration and changes in implied volatility.

We will return on many occasions to this concept of asymmetry of the P&L curve. It is rarely worth attempting to extract the last nickel of profit from a trade that has delivered substantial profits.

The non linear nature of the P&L curve of most option trades dictates that the risk / reward be understood and monitored carefully in order to deliver the highest probability of a successful trade.

Next week we will again return to this interesting family of trade structures and discuss the characteristics of two particularly interesting trades, the iron butterfly and the iron condor.

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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