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9 Weeks to Better Options Trading: Butterfly Spreads


Veteran options trader Steve Smith breaks down a key strategy.

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 (NYSEARCA: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.
No positions in stocks mentioned.

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