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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.
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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