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Options Trading -- Is the Butterfly Spread a Worthwhile Strategy?

Posted August 11, 2011

Topics: Finance & Investing

The idea of limiting risk is always appealing. But if limiting risk also means accepting very small profits, several questions come up:

            1. Is it worth the margin requirements?

            2. Can my capital be better employed elsewhere?

            3. Will the strategy take too much effort to manage and track?

These questions should be addressed for strategies like the butterfly spread.

In the butterfly, you open either calls or puts (or both) in long or short positions (or both).

For example, you 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).

You execute this butterfly with the following net outcome:

            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 for your $95 cost, here’s the bottom line 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 changes from 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 problem is that you need to have the stock close in a very narrow range to earn a profit that justifies the position; and by the way, none of these examples include trading costs.

The big advantage of this butterfly example 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 by itself. But the complexity of the butterfly and the limit on potential profits, even in the ideal price outcome, makes it questionable.

Butterflies can also consist of only puts, or combinations of 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. You need 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. And you aren’t. In one sense, butterflies are very conservative, accepting small maximum losses in exchange for the remote chance of large profits. In another sense, its main appeal is its complexity. If you want bragging rights at a cocktail party where you think it’s impressive to tell people you’re a player in options, butterflies are the perfect strategy for you: complicated but not all that risky. But remember two things: First, you are going to need to monitor the position. Second, those other people are not really going to be all that impressed; they might find it all simply boring.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches five  courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.”  He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to several blogs: CBOE, Seeking Alpha and the Global Risk Community.