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9 Weeks to Better Options Trading: Butterfly Spreads

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Veteran options trader Steve Smith breaks down a key strategy.

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Editor's note: To help investors profitably navigate the options market, Minyanville is launching "9 Weeks to Better Options Trading," an educational series aimed at increasing trader understanding of the nuts and bolts of options, with an emphasis on real-world applications. In this series, veteran options trader and author of OptionSmith (Click here for a two-week FREE trial and get Steve's best trading ideas in real time) Steve Smith will demystify a range of topics from options pricing to trading strategies to special situations like earnings reports and takeovers.

For the first article in the series, click here.

If you are a novice options trader, we suggest you start with Steve Smith's 6-Week Options Trading Kickstarter series.

Do not touch nothing. The truth will be revealed by the facts as they exist.
-- Hercule Poirot's in The Murder on the Orient Express

One of the biggest challenges in using options as an investment tool is that not only must you be right on direction and price target, but you must also be accurate in your timing. You can buy a call with too short an expiration period, watch the stock go up, and actually lose money because time decay will offset most or all of the directional gains if the move does not come quickly enough.

Butterfly spreads are a good, low-cost way to establish positions that are not impacted by time decay or short-term price movement. Due to their balanced construction, their value only becomes price sensitive -- albeit exponentially so -- as expiration approaches.

In this way, one can eliminate the need to be right about the velocity of the price move -- you need only be correct about the price level at expiration. This makes butterfly spreads useful as both protective positions and potentially highly profitable directional bets.

A Stack of Spreads

A butterfly is a three-strike position that involves a combination of the following:
  • The sale (or purchase) of 2 identical options
  • The purchase (or sale) of 1 option with an immediately higher strike than the 2 identical
  • The purchase (or sale) of 1 option with an immediately lower strike than the 2 identical
All options must have the same underlying stock and have the same expiration date. One way to think of butterflies is as a combination of two vertical spreads -- one bullish and one bearish -- with a common middle strike. We call this a 1 x 2 x 1 construction.

Today, we'll focus on the long butterfly, in which the two outside strikes are purchased and the "body," or center strike, is sold for a net debit.

This "stack of spreads" (one long, one short) creates a position that is initially near both delta and theta neutral. This means that changes in price and time, and even implied volatility, have little impact on the value of the position. This strategy's name undoubtedly is derived from its structure of a midsection and two equidistant outside pieces.

This creates a profit-loss diagram with two "wings" in which the middle common strike is typically sold short and represents the price of maximum profit on expiration day.

For example; with Google (GOOG) currently trading around $645 one could:
  • Buy 1 April $650 call for $21 a contract
  • Sell 2 April $670 calls for $13 a contract
  • Buy 1 April $690 call for $8 a contract
This is a $3 net debit (2 x $13 = $26, while $21 + $8 = $29). That $3 is the maximum loss and would be incurred if shares of Google make a big move -- in this case, if they are below $650 or above $690 on the April 21 expiration. The maximum profit is $17 (calculated by the width between strikes minus the cost, or $20 - $3, which gives us $17) and would be realized if Google is exactly at $670 on expiration.

Low Maintenance

Butterfly positions are often referred to as "vacation positions" in that they're low-cost and have minimum risk, and you can basically put them on and forget about them for a while. For most retail investors, there's no need for monitoring or adjustments on a daily or even weekly basis, until expiration approaches. The trade-off is that significant profits can only be realized near expiration.

As expiration approaches, the position's gamma, or rate of change in delta, increases dramatically, so incremental profits that might have accrued over a few weeks can evaporate in a few days.

However, the low-cost nature of these positions can make them very useful as a portfolio protection tool for less active traders.

Let's assume that one would like to hedge downside risk in a reasonably diversified portfolio. It might make sense to buy some wide width butterfly spreads -- let's say $10 between strikes -- on the Spyder Trust (SPY) that would land in the profit zone on a 5% to 10% market decline.

More active traders often use butterflies in multiple layers to maintain an inventory of spreads that can deliver both profits across several price levels and expirations to trade against shorter-term price swings.

For example, one technique I like to employ in the OptionSmith portfolio is establishing sizable put butterflies in the SPY. If there is a subsequent decline, which will usually have an accompanying increase in implied volatility, and shares move toward the profit zone, I can sell shorter-term (i.e., weekly) puts against the butterfly spreads to capture premium and scalp short-term profits.

This worked quite well in the summer and fall of 2011 as intra- and interday volatility provided frequent opportunities to sell short-term puts against the much larger, longer-term butterfly spreads. In terms of number of contracts, to keep risk limited I might sell short 10 puts for every 50 butterflies I was long and look to scalp that for $1 profit.

Breaking a Wing

Another strategy I frequently use for shorter-term, aggressive directional bets is what is called a broken wing, or skip strike butterfly. This will usually involve a 1 x 3 x 2 construction, in which a strike is skipped. So in the Google example above one might:
  • Buy 1 April $650 call at $21
  • Sell 3 April $680 calls at $10
  • Buy 2 April $690 calls at $7.50
This would currently cost $6 net debit. This is calculated as follows: 3 x $10 = $30, from which we subtract $21 and $15 (2 x $7.50), which gives $6.

While the $6 outlay here is greater than the $4 above, it expands the maximum profit to $24 for a 6:1 risk/reward.

This $24 is the width between the long $650 call and the short $680 strike, minus the total cost of the spread, or $30 - $6, which equals $24. It also expand the range in which a profit will be realized. Unlike a 1 x 2 x 1 position in which losses are incurred above the higher strike, in this case, if shares are above $690, the spread will still be worth $10, meaning the position still produces a profit of $4 no matter how much above $690 shares are at expiration.

Given the price stability of these spreads, this can be an especially powerful tool for playing earnings during an expiration week. Given that many of the most actively traded and biggest earnings movers like Amazon (AMZN), Salesforce (CRM), and Google offer weekly options, there should be plenty of opportunities as we head into earnings season to try to catch one of these powerful butterflies in coming weeks.

For complete access to Steve Smith's trades in real-time, check out the OptionSmith portfolio, which returned 28% in 2011. Click here for more details.

Here is a complete schedule for "9 Weeks to Better Options Trading":

Week 1: 5 Rookie Mistakes Options Traders Make

Week 2: Option Pricing Basics: Understanding Implied Volatility and Time Decay

Week 3: Trading Strategy: The Power of Calendar Spreads

Week 4: Trading Strategy: Butterfly Spreads

Week 5: Trading Strategy: Iron Condors

Week 6: Trading Strategy: Risk/Reversal

Week 7: Trading Strategy: Back Spreads

Week 8: Managing Risk

Week 9: Special Situations: Earnings Reports, Takeovers, and Extreme Market Moves
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No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

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