option-info and options-graphs sites:
Outlook: Bearish. Expecting a drop in the stock 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 next strike below the current stock price, buy calls
one strike higher and buy puts one strike lower than the short strike.
when: Stock moves to and stays in a narrow range near the sold strike.
Gain: On an "Iron" Butterfly, limited to the initial credit.
when: Stock does not fall to the lower breakeven point, or moves
beyond the lower breakeven point.
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 short stock: Increased leverage, much less capital required,
"built-in" stop loss, can gain from a drop in implied volatility.
compared to short stock: Will lose if stock 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 the Bearish Butterfly is a possible strategy
to use at earnings time on a stock whose volatility has risen, and you
expect some downward movement in 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
drop as well as the drop in the stock price.
scenario is a stock trading within a channel, that has recently risen
to the top of the channel or above. If you think the move is over-enthusiastic,
and especially if the implied volatility has risen because of too much
enthusiasm, a Bearish Butterfly could be a good strategy. If the stock
falls back within the channel and the volatility drops as enthusiasm
wanes, a Bearish Butterfly would benefit from both the drop in the stock
price, and the return to a normal (lower) implied volatility.
- The Bearish
Butterfly can be used as a limited-protection strategy for stock owners.
Using the example graph for instance, this strategy could be employed
by someone committed to owning the stock who thought there was a possibility
of the stock dropping to 45 after a disappointing earnings report. Buying
an ATM 50 strike Long Put for protection would cost $189, and would
gain by $311 if the stock did fall to 45. Using the Bearish Butterfly,
the entry is made for a credit, the maximum possible loss is $130, and
the strategy would gain by $370 if the stock fell to exactly 45. The
tradeoff is that the protection with the Bearish Butterfly falls off
rapidly below the "sweet spot", whereas the Long Put would
continue to gain.
- If you
have a bearish outlook, but want to benefit from an increase in volatility,
the Calendar Call, ITM is a similar
strategy. 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 Bearish
Butterfly trade gains if the stock moves to a narrow range around the
short strike and time passes. If the stock rises, or moves beyond the
lower breakeven 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 40 or 51 at any time, it would be wise to cut the losses
short at about $50, which is about half 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.
the normal Butterfly, the Bearish Butterfly strategy can be set up with
all Calls or all Puts, and the graph is nearly identical to the Bearish
"Iron" Butterfly. The main difference is the Iron Butterfly
is entered for a credit, whereas the strategy using all calls or all puts
has an initial debit. See the Butterfly
page for graphs with all calls or all puts.
If you are
more bearish than might make sense with a normal Bearish Butterfly, you
can use a "modified" Bearish Butterfly as shown in the graph
below. This strategy will show greater gains at the "sweet spot",
and will not lose at any price if the stock drops. The tradeoff is that
there is more of a loss if the stock rises. The modified Bearish Butterfly
is constructed by buying the long call one strike higher than normal.
Your broker will require more margin for the modified Butterfly - up to
$1000 on the example shown.
a modified Bearish Butterfly, it makes sense to compare it to a Bear Call
using similar strikes, as shown below. The Bear Call will respond more
quickly to a drop in prices, keeps the gains on any drop beyond the short
strike, and requires fewer commissions. The modified Bearish Butterfly
will respond more quickly to a drop in implied volatility and allows for
very slight stock price movement to the upside.