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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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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.
No positions in stocks mentioned.

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