Option Trading Subjects:
Strategy: Butterfly, Bullish
The Outlook: Bullish. Expecting a good rise in the stock before the expiration of the options. Entering when volatility is high is preferable.
The Trade: For the trade graphed above, an "Iron" Butterfly, sell puts and calls at the next strike price above the current stock price, buy calls one strike higher and buy puts one strike lower.
Gains when: Stock moves to and stays in a narrow range near the sold strike.
Maximum Gain: On an "Iron" Butterfly, limited to the initial credit.
Loses when: Stock does not rise to the lower breakeven point, or moves beyond the higher breakeven point.
Maximum Loss : Limited to the largest difference in strike prices on one side times the number of shares represented, less the initial credit.
Breakeven Calculation: (For an "Iron" Butterfly) Lower breakeven = sold strike price - initial credit. Upper breakeven = sold strike price + initial credit.
Advantages compared to stock: Increased leverage, much less capital required, "built-in" stop loss, can gain from a drop in implied volatility.
Disadvantages compared to stock: Will lose if stock rises too much.
Volatility: after entry, increasing implied volatility is negative.
Time: after entry, the passage of time is positive.
Margin 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.
Variations: Use all calls or all puts. An "Iron" Butterfly is called Iron because it uses both puts and calls.
Just like the normal Butterfly, the Bullish Butterfly strategy can be set up with all Calls or all Puts, and the graph is nearly identical to the Bullish "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 bullish than might make sense with a normal Bullish Butterfly, you can use a "modified" Bullish 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 rises. The tradeoff is that there is more of a loss if the stock drops. The modified Bullish Butterfly is constructed by buying the long put one strike lower than normal. Your broker will require more margin for the modified Butterfly - up to $1000 on the example shown.
Before using a modified Bullish Butterfly, it makes sense to compare it to a Bull Call using similar strikes, as shown below. The Bull Call will respond more quickly to a rise in prices, keeps the gains on any rise beyond the short strike, is entered for a debit, does not require margin, and requires fewer commissions. The modified Bullish Butterfly will respond more quickly to a drop in implied volatility, is entered for a credit, requires margin, and allows for very slight stock price movement to the downside.