Butterfly option strategy gives a credit for entry, gains if the stock
does not move, and has a known and limited maximum loss.
option-info and options-graphs sites:
Outlook: Neutral. Not expecting movement up or down before the expiration
of the options. Entering when volatility is high is preferable.
For the trade graphed above, an "Iron" Butterfly, sell
puts and calls at the strike price nearest the stock price, buy calls
one strike higher and buy puts one strike lower.
when: Stock stays in a narrow range near the sold strike.
Gain: On an "Iron" Butterfly, limited to the initial credit.
when: Stock moves beyond one of the breakeven points.
Loss : Limited to the largest difference in strike prices on one side
times the number of shares represented, less the initial credit.
Calculation: (For an "Iron" Butterfly) Lower breakeven
= sold strike price - initial credit. Upper breakeven = sold strike price
+ initial credit.
compared to stock: Increased leverage, much less capital required,
"built-in" stop loss, can gain from no stock movement or limited
stock movement, can gain from a drop in implied volatility.
compared to stock: Will lose if stock rises or falls too much.
after entry, increasing implied volatility is negative.
after entry, the passage of time is positive.
Requirement : Most options-oriented brokers will require the difference
in the strike prices x the number of shares represented, reduced by the
amount of credit taken in. In the example above the margin would be $187.
Use all calls or all puts. An "Iron" Butterfly is called
Iron because it uses both puts and calls.
- A Butterfly
trade is an "anti-gambler's trade". There is a good chance
of a small profit, and a small chance of a loss. If you manage the trade
so that you only take relatively small losses and not the maximum possible
loss, you increase your chances of coming out ahead over the long term.
- A Butterfly
trade can be thought of as a safer alternative to selling a Straddle.
Just selling a Straddle could expose you to unlimited losses. The long
options that are part of the Butterfly trade serve to limit losses to
a manageable amount, even if the stock moves unexpectedly beyond one
of the breakeven points.
trades require a large commission expense. Entering the trade will cost
four commissions, and if you need to exit early there will be another
four commissions. If you do not use the lowest-commission discount option
brokers, the Butterfly trade might not make much sense. With most brokers,
using more contracts will result in lower per-leg commissions overall
and might make the trade reasonable.
- The Butterfly
is an "anti-volatility" trade: it will benefit from a drop
in volatility. For this reason it is a possible strategy to use at earnings
time on a stock whose volatility has risen, but you do not expect the
earnings report to really move the stock. After the earnings are out,
the options may experience a "volatility crush", meaning they
drop back to normal volatility, and the trade may benefit from that
- If you
have a neutral outlook, but want to benefit from an increase in volatility,
the Calendar Call fits the
bill. Plus, it requires only two commissions.
- The Butterfly
strategy gets it's name from the graph. It reminded traders of a small
creature with wings. Compare
to the Condor graph, that looks like something
bigger with wings.
- The Butterfly
trade gains if the stock stays in a narrow range around the short strike
and time passes. If the stock moves to one of the breakeven points at
any time, the losses can multiply quickly up to the maximum possible.
Using the graph at the top of the page, if the stock were to move to
46 or 54 at any time, it would be wise to cut the losses short at about
$50, which is about a third of the maximum possible loss.
- If the
reason for entry was to capture a decline in volatility, then an exit
when the volatility drops makes sense.
- This trade
is similar to the Calendar Call
in that the closer you are to expiration, the greater your risk of giving
back any gains you have. For this reason, it may be a good idea to exit
Butterfly trades when there is a week left to expiration. See the Delta
Neutral Trading page for more information.
below show that the Butterfly strategy can be set up with all Calls or
all Puts, and the graph is nearly identical to the "Iron" Butterfly.
The main difference is the Iron Butterfly is entered for a credit, and
these trades have an initial debit.