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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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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 (NASDAQ:AMZN), Salesforce (NYSE: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
No positions in stocks mentioned.

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