Butterfly option strategy offers a limited risk way to take advantage
of stock movement up or down.
option-info and options-graphs sites:
Outlook: Bullish or bearish, but not neutral. The stock must fall
or rise for the strategy to gain.
buy Put and Call ATM, sell Call one strike OTM, sell Put one strike
OTM. See end of page for credit variations.
when: stock rises or falls past the breakeven points.
Gain: Limited to difference in strike prices - initial debit (for
when: stock does not rise or fall enough.
Loss : limited to the initial debit (for this variation).
Calculation: Lower breakeven = middle strike - initial debit. Upper
breakeven = middle strike + initial debit. (For this variation.)
compared to stock: limited risk, less capital needed, greater leverage,
can gain from a move in either direction.
compared to stock: Position will lose if stock does not move, or does
not move enough.
after entry, increasing implied volatility is positive.
after entry, the passage of time is negative if the stock does not
move, but positive if the stock rises or falls past the breakeven points.
Requirement: None for this variation, after initial debit is paid
See the bottom of this page for credit-entry variations using all
calls or all puts.
- The Reverse
Butterfly can be used if you expect a sharp stock price movement one
way or the other. For instance, you may expect such a movement at earnings
time on a stock that historically has large movements in reaction to
the earnings report, but you feel earnings could be either disappointing
- The strategy
has limited profit potential to the upside and the downside, so you
don't want to be "too" bullish or bearish. Use the Backspread
with Calls if you are more bullish than bearish, the Backspread
with Puts if you are more bearish than bullish, or the Straddle
Purchase if you are expecting a large move in either direction.
- A somewhat
similar strategy is the Straddle Purchase.
Compared to a Straddle Purchase, the Reverse Butterfly:
entered for less of a debit (or for a credit on the variations shown
a lower maximum loss.
gain as much if the stock rises or falls dramatically.
this strategy needs stock price movement to be profitable, if the stock
does not move as expected, it is best to exit the trade with less than
the maximum loss. Using the example graph, if the stock has not moved
within two weeks (and you were expecting the movement by then), you
can exit with a loss of about $75. If you just sit and wait, you may
have to take a loss of over four times that much - $311.
- If the
stock rises or falls past one of the breakeven points, time will work
in your favor at that stock price, so you may want to hold on for maximum
gains. However, there is always the chance of a reversal that might
take the stock price back to the worst possible range.
the example graph, if you determine to take your losses at $75, you
might also take any gains of around $150 whenever you have them, and
eliminate the risk of a possible stock price move against you.
- The example
position can be thought of as a combination of a Bull Call and a Bear
Put. If you feel the stock is going to trend, and the stock starts moving
higher, you can close out the Bear Put and try to stick with the Bull
Call. Or if the stock starts moving lower, you can close out the Bull
Call and stick with the Bear Put.
- A completely
opposite strategy if you think the stock is going to bounce around,
would be to take the gains on whichever side is winning, wait for a
reversal, and take gains on the other side as well.
needs to work out just right for either of the above two techniques
to succeed. In the long run, you may be better off following a "take
small losses and larger gains" philosophy rather than trying to
predict stock movement too precisely.
the Butterfly, the Reverse Butterfly can be constructed with all calls
or all puts, for a nearly identical position. The main difference is both
of these variations are entered for a credit and will require margin.