By  Jul 1, 2010

Topics: Finance & Investing

Everyone wants to limit risks, but if you also limit potential profits, is it worth the trouble? The butterfly spread comes in several varieties, but normally involves two positions offset by a third and fourth, one with a higher strike and one with a lower strike. Some will ask: What’s the point? With options, you normally take a relatively small risk of 100% loss for the possible big profit. Doesn’t the butterfly spread end up being much ado about nothing?

Here’s how it works. You take up positions in either calls or puts and use both long and short positions. For example, you might sell two 80 calls and at the same time, buy one 85 and one 95 call. The idea is that the cost is going to be minimal, but the position does create a nine-point profit range in the middle (and a limited loss range above and below).

In one example, you could execute the butterfly like this:

Buy 1 February 85 call            -   9.90

Sell 2 February 90 calls           +11.80

Buy 1 February 95 call            -   2.85

Net cost                       -   0.95

So what do you get for your \$95? Here’s the outcome at expiration:

1) If the stock price moves to \$95 or above, you lose \$95 (your original cost).

2) If the stock price moves to \$86 or below, you lose \$95.

3) If the stock’s price remains in between \$87 and \$94, you make a profit.

The middle profit range moves point for point. So at a closing price of \$86 or \$94, you net out a \$5 net profit (without deducting trading costs). The profit level moves upward point for point as the closing price level changes. The maximum is a closing price for the stock of \$90 per share. At that level, your profit will be \$405. This is accomplished by a combination of the two short calls expiring worthless because they are at the money and won’t be exercised; and offsetting losses of \$285 on the 95 strike long call, and \$490 net loss on the 85 call (five points below cost but still closed for intrinsic value).

The big advantage of this variation of a butterfly is that your potential losses are never greater than the net you pay to open the position; but at the same time you could make a profit of up to \$405. That’s not bad in the context of the limited cost and risk. But for many traders, the complexity of the butterfly coupled with the limitation of potential profits, even in the idea price outcome, makes it a strategy of questionable value.

Butterflies can also be constructed using only puts, or in combination between calls and puts. For example, an iron butterfly involves combining long and short calls as well as long and short puts. You end up with the same structural result, limited losses with a profit zone in between. Every trader needs to decide whether the exotic structure of the butterfly in its many configurations is worth the time and trouble.

Some traders will admit that they open such positions for the excitement and complexity, but they should also recognize that they aren’t going to get rich. When was the last time you heard of a billionaire who built a fortune based on butterfly spreads? Exactly.

Michael C. Thomsett is an options author and has written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Put Option Strategies for Smarter Trading.