An investor who buys a butterfly pays a premium somewhere between the minimum and maximum value, and profits if the butterfly's value moves toward the maximum as expiration approaches. The strategy breaks even if at expiration the underlying stock is above the lower strike or below the upper strike by the amount of premium paid to initiate the position.
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An increase in implied volatility, all other things equal, will usually have a slightly negative impact on this strategy. The passage of time, all other things equal, will usually have a positive impact on this strategy if the body of the butterfly is at-the-money, and a negative impact if the body is away from the money. The short calls that form the body of the butterfly are subject to exercise at any time, while the investor decides if and when to exercise the wings. The components of this position form an integral unit, and any early exercise could be disruptive to the strategy.
Iron Butterfly Options Strategy - The Options Playbook
In general, since the cost of carry makes it optimal to exercise a call option on the last day before expiration, this usually does not pose a problem. But the investor should be wary of using this strategy where dividend situations or tax complications have the potential to intrude. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock.
This strategy has an extremely high expiration risk. Consider that the maximum profit occurs when at expiration if the stock is trading right at the body of the butterfly. Presumably the investor will choose to exercise their in-the-money wing, but there is no way of knowing for sure whether none, one or both of the calls in the body will be exercised.
If the investor guesses wrong, they face the risk of the stock opening sharply higher or lower when trading resumes after the expiration weekend. Comparable Position: Long Put Butterfly.
Long butterfly spread with calls
Opposite Position: Short Call Butterfly. Long Call Butterfly This strategy profits if the underlying stock is at the body of the butterfly at expiration. Description Combining two short calls at a middle strike, and one long call each at a lower and upper strike creates a long call butterfly. What many option traders do not know or may not consider is that butterfly spreads can be used directionally by moving the body short options of the butterfly out-of-the-money OTM and using slightly wider strike prices for the wings long options.
This lets the trader make a directional forecast on the stock with a fairly large profit zone depending on the width of the wings. To implement a directional butterfly, a trader needs to include both price and time in his outlook for the stock.
This can be the most difficult part for either a neutral or directional butterfly: picking the time the stock will be trading in the profit zone. Sometimes the stock will reach the area too soon and other times not until after expiration. Another way to use butterfly spreads is to reduce risk or lock in profits for a profitable long option or vertical debit spread position. There are several ways to make adjustments or lock in profits on a profitable position, but one of my favorites has to be converting the option position to a long butterfly spread.
It may sound funny, but probably the hardest part about an option trader converting his position to lock in profits with a butterfly spread is getting to a profitable position in the first place. This can work out well if the underlying is expected to remain close to the short options body of the butterfly after the conversion. He or she can sell 2 of the 70 calls and an additional long 80 call with the same expiration constructing a butterfly.
Sometimes, even a credit can be established with the construction of the butterfly spread effectively eliminating any risk. An option trader thinks the stock will continue to trade in the channel even longer.
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A long call butterfly spread is constructed with just over a week to go until expiration Mar A 69 strike call is bought, two 72 strike calls are sold and an additional 75 strike is purchased, all with Mar expiration. After middling the market, the spread is purchased for 0.
Options Guy's Tips
The maximum profit is 2. Maximum loss is the cost. The breakevens are calculated by adding the cost to the lowest strike and subtracting the cost from the highest strike. If the stock closes anywhere between those levels at expiration, a profit would be realized. Of course, the position can and usually should be exited before expiration. As I often think, it is great to have options on your options. With butterfly spreads, that is true for so many different scenarios as well. Adding these spreads to your arsenal as an option trader should give you another weapon for extracting money from the markets and an additional edge you may have not realized.
Options involve risk and are not suitable for all investors. Franklin St. No statement on this site is intended to be a recommendation or solicitation to buy or sell any security or to provide trading or investment advice.
Long Put Butterfly
Traders and investors considering options should consult a professional tax advisor as to how taxes may affect the outcome of contemplated options transactions. Futures and forex trading contains substantial risk and is not for every investor. An investor could potentially lose all or more than the initial investment. Risk capital is money that can be lost without jeopardizing ones financial security or life style. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. Past performance is not necessarily indicative of future results.
Back to Blog. Butterfly Spread Trading Strategy Explained. Thursday, March 04, What Is a Butterfly Spread? Effect of Time with Butterfly Spread The goal of the trade is to benefit from time decay as the stock moves closer to the short options strike price at expiration.