Options trading strategies butterfly

10 Options Strategies to Know.

10 Options Strategies To Know.

Too often, traders jump into the options game with little or no understanding of how many options strategies are available to limit their risk and maximize return. With a little bit of effort, however, traders can learn how to take advantage of the flexibility and full power of options as a trading vehicle. With this in mind, we've put together this slide show, which we hope will shorten the learning curve and point you in the right direction.

10 Options Strategies To Know.

Too often, traders jump into the options game with little or no understanding of how many options strategies are available to limit their risk and maximize return. With a little bit of effort, however, traders can learn how to take advantage of the flexibility and full power of options as a trading vehicle. With this in mind, we've put together this slide show, which we hope will shorten the learning curve and point you in the right direction.

1. Covered Call.

Aside from purchasing a naked call option, you can also engage in a basic covered call or buy-write strategy. In this strategy, you would purchase the assets outright, and simultaneously write (or sell) a call option on those same assets. Your volume of assets owned should be equivalent to the number of assets underlying the call option. Investors will often use this position when they have a short-term position and a neutral opinion on the assets, and are looking to generate additional profits (through receipt of the call premium), or protect against a potential decline in the underlying asset's value. (For more insight, read Covered Call Strategies For A Falling Market.)

2. Married Put.

In a married put strategy, an investor who purchases (or currently owns) a particular asset (such as shares), simultaneously purchases a put option for an equivalent number of shares. Investors will use this strategy when they are bullish on the asset's price and wish to protect themselves against potential short-term losses. This strategy essentially functions like an insurance policy, and establishes a floor should the asset's price plunge dramatically. (For more on using this strategy, see Married Puts: A Protective Relationship . )

3. Bull Call Spread.

In a bull call spread strategy, an investor will simultaneously buy call options at a specific strike price and sell the same number of calls at a higher strike price. Both call options will have the same expiration month and underlying asset. This type of vertical spread strategy is often used when an investor is bullish and expects a moderate rise in the price of the underlying asset. (To learn more, read Vertical Bull and Bear Credit Spreads.)

4. Bear Put Spread.

The bear put spread strategy is another form of vertical spread​ like the bull call spread. In this strategy, the investor will simultaneously purchase put options at a specific strike price and sell the same number of puts at a lower strike price. Both options would be for the same underlying asset and have the same expiration date. This method is used when the trader is bearish and expects the underlying asset's price to decline. It offers both limited gains and limited losses. (For more on this strategy, read Bear Put Spreads: A Roaring Alternative To Short Selling.)

Investopedia Academy "Options for Beginners"

Now that you've learned a few different options strategies, if you're ready to take the next step and learn to:

Improve flexibility in your portfolio by adding options Approach Calls as down-payments, and Puts as insurance Interpret expiration dates, and distinguish intrinsic value from time value Calculate breakevens and risk management Explore advanced concepts such as spreads, straddles, and strangles.

5. Protective Collar.

A protective collar strategy is performed by purchasing an out-of-the-money put option and writing an out-of-the-money call option at the same time, for the same underlying asset (such as shares). This strategy is often used by investors after a long position in a stock has experienced substantial gains. In this way, investors can lock in profits without selling their shares. (For more on these types of strategies, see Don't Forget Your Protective Collar and How a Protective Collar Works.)

6. Long Straddle.

A long straddle options strategy is when an investor purchases both a call and put option with the same strike price, underlying asset and expiration date simultaneously. An investor will often use this strategy when he or she believes the price of the underlying asset will move significantly, but is unsure of which direction the move will take. This strategy allows the investor to maintain unlimited gains, while the loss is limited to the cost of both options contracts. (For more, read Straddle Strategy A Simple Approach To Market Neutral . )

7. Long Strangle.

In a long strangle options strategy, the investor purchases a call and put option with the same maturity and underlying asset, but with different strike prices. The put strike price will typically be below the strike price of the call option, and both options will be out of the money. An investor who uses this strategy believes the underlying asset's price will experience a large movement, but is unsure of which direction the move will take. Losses are limited to the costs of both options; strangles will typically be less expensive than straddles because the options are purchased out of the money. (For more, see Get A Strong Hold On Profit With Strangles.)

8. Butterfly Spread.

All the strategies up to this point have required a combination of two different positions or contracts. In a butterfly spread options strategy, an investor will combine both a bull spread strategy and a bear spread strategy, and use three different strike prices. For example, one type of butterfly spread involves purchasing one call (put) option at the lowest (highest) strike price, while selling two call (put) options at a higher (lower) strike price, and then one last call (put) option at an even higher (lower) strike price. (For more on this strategy, read Setting Profit Traps With Butterfly Spreads . )

9. Iron Condor.

An even more interesting strategy is the iron condor. In this strategy, the investor simultaneously holds a long and short position in two different strangle strategies. The iron condor is a fairly complex strategy that definitely requires time to learn, and practice to master. (We recommend reading more about this strategy in Take Flight With An Iron Condor, Should You Flock To Iron Condors? and try the strategy for yourself (risk-free!) using the Investopedia Simulator.)

10. Iron Butterfly.

The final options strategy we will demonstrate here is the iron butterfly. In this strategy, an investor will combine either a long or short straddle with the simultaneous purchase or sale of a strangle. Although similar to a butterfly spread, this strategy differs because it uses both calls and puts, as opposed to one or the other. Profit and loss are both limited within a specific range, depending on the strike prices of the options used. Investors will often use out-of-the-money options in an effort to cut costs while limiting risk. (To learn more, read What is an Iron Butterfly Option Strategy?)

Advanced Option Trading: The Modified Butterfly Spread.

The majority of individuals who trade options start out simply buying calls and puts in order to leverage a market timing decision, or perhaps writing covered calls in an effort to generate income. Interestingly, the longer a trader stays in the option trading game, the more likely he or she is to migrate away from these two most basic strategies and to delve into strategies that offer unique opportunities. One strategy that is quite popular among experienced option traders is known as the butterfly spread. This strategy allows a trader to enter into a trade with a high probability of profit, high profit potential and limited risk. In this article we will go beyond the basic butterfly spread and look at a strategy known as the "modified butterfly."

[ Need a refresher on options before you break out of your cocoon and start exploring butterfly spreads? Investopedia Academy's Options for Beginners course gives you a robust overview of options, from basic puts and calls, to advanced strategies like strangles and straddles, all taught by a veteran options trader and strategist. ]

The Basic Butterfly Spread.

Before looking at the modified version of the butterfly spread, let's do a quick review of the basic butterfly spread. The basic butterfly can be entered using calls or puts in a ratio of 1 by 2 by 1. This means that if a trader is using calls, he will buy one call at a particular strike price, sell two calls with a higher strike price and buy one more call with an even higher strike price. When using puts, a trader buys one put at a particular strike price, sells two puts at a lower strike price and buys one more put at an even lower strike price. Typically the strike price of the option sold is close to the actual price of the underlying security, with the other strikes above and below the current price. This creates a "neutral" trade whereby the trader makes money if the underlying security remains within a particular price range above and below the current price. However, the basic butterfly can also be used as a directional trade by making two or more of the strike prices well beyond the current price of the underlying security. (Learn more about basic butterfly spreads in Setting Profit Traps With Butterfly Spreads .)

Figure 1 displays the risk curves for a standard at-the-money, or neutral, butterfly spread. Figure 2 displays the risk curves for an out-of-the-money butterfly spread using call options.

Both of the standard butterfly trades shown in Figures 1 and 2 enjoy a relatively low and fixed dollar risk, a wide range of profit potential and the possibility of a high rate of return.

Moving on to the Modified Butterfly.

The modified butterfly spread is different from the basic butterfly spread in several important ways:

1. Puts are traded to create a bullish trade and calls are traded to create a bearish trade.

2. The options are not traded in 1x2x1 fashion, but rather in a ratio of 1x3x2.

3. Unlike a basic butterfly that has two breakeven prices and a range of profit potential, the modified butterfly has only one breakeven price, which is typically out-of-the-money. This creates a cushion for the trader.

4. One negative associated with the modified butterfly versus the standard butterfly; while the standard butterfly spread almost invariably involves a favorable reward-to-risk ratio, the modified butterfly spread almost invariably incurs a great dollar risk compared to the maximum profit potential. Of course, the one caveat here is that if a modified butterfly spread is entered properly, the underlying security would have to move a great distance in order to reach the area of maximum possible loss. This gives alert traders a lot of room to act before the worst-case scenario unfolds.

Figure 3 displays the risk curves for a modified butterfly spread. The underlying security is trading at $194.34 a share. This trade involves:

-Buying one 195 strike price put.

-Selling three 190 strike price puts.

-Buying two 175 strike price puts.

A good rule of thumb is to enter a modified butterfly four to six weeks prior to option expiration. As such, each of the options in this example has 42 days (or six weeks) left until expiration.

Note the unique construction of this trade. One at-the-money put (195 strike price) is purchased, three puts are sold at a strike price that is five points lower (190 strike price) and two more puts are bought at a strike price 20 points lower (175 strike price).

There are several key things to note about this trade:

1. The current price of the underlying stock is 194.34.

2. The breakeven price is 184.91. In other words, there are 9.57 points (4.9%) of downside protection. As long as the underlying security does anything besides declining by 4.9% or more, this trade will show a profit.

3. The maximum risk is $1,982. This also represents the amount of capital that a trader would need to put up to enter the trade. Fortunately, this size of loss would only be realized if the trader held this position until expiration and the underlying stock was trading at $175 a share or less at that time.

4) The maximum profit potential on this trade is $1,018. If achieved this would represent a return of 51% on the investment. Realistically, the only way to achieve this level of profit would be if the underlying security closed at exactly $190 a share on the day of option expiration.

5. The profit potential is $518 at any stock price above $195 - 26% in six weeks' time.

Key Criteria to Consider in Selecting a Modified Butterfly Spread.

The three key criteria to look at when considering a modified butterfly spread are:

1. Maximum dollar risk.

3. Probability of profit.

Unfortunately, there is no optimum formula for weaving these three key criteria together, so some interpretation on the part of the trader is invariably involved. Some may prefer a higher potential rate of return while others may place more emphasis on the probability of profit. Also, different traders have different levels of risk tolerance. Likewise, traders with larger accounts are better able to accept trades with a higher maximum potential loss than traders with smaller accounts.

Each potential trade will have its own unique set of reward-to-risk criteria. For example, a trader considering two possible trades might find that one trade has a probability of profit of 60% and an expected return of +25%, while the other might have a probability of profit of 80% but an expected return of only 12%. In this case the trader must decide whether he or she puts more emphasis on the potential return or the likelihood of profit. Also, if one trade has a much greater maximum risk/capital requirement than the other, this too must be taken into account.

Options offer traders a great deal of flexibility to craft a position with unique reward-to-risk characteristics. The modified butterfly spread fits into this realm. Alert traders who know what to look for and who are willing and able to act to adjust a trade or cut a loss if the need arises, may be able to find many high probability modified butterfly possibilities.

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Neutral Option Strategies » Butterfly.

The long butterfly spread is a three-leg strategy that is appropriate for a neutral forecast - when you expect the underlying stock price (or index level) to change very little over the life of the options.

A butterfly can be implemented using either call or put options. For simplicity, the following explanation discusses the strategy using call options.

A long call butterfly spread consists of three legs with a total of four options: long one call with a lower strike, short two calls with a middle strike and long one call of a higher strike. All the calls have the same expiration, and the middle strike is halfway between the lower and the higher strikes. The position is considered "long" because it requires a net cash outlay to initiate.

When a butterfly spread is implemented properly, the potential gain is higher than the potential loss, but both the potential gain and loss will be limited.

The total cost of a long butterfly spread is calculated by multiplying the net debit (cost) of the strategy by the number of shares each contract represents. A butterfly will break-even at expiration if the price of the underlying is equal to one of two values. The first break-even value is calculated by adding the net debit to the lowest strike price. The second break-even value is calculated by subtracting the net debit from the highest strike price. The maximum profit potential of a long butterfly is calculated by subtracting the net debit from the difference between the middle and lower strike prices. The maximum risk is limited to the net debit paid for the position.

Butterfly spreads achieve their maxim profit potential at expiration if the price of the underlying is equal to the middle strike price. The maximum loss is realized when the price of the underlying is below the lowest strike or above the highest strike at expiration.

As with all advanced option strategies, butterfly spreads can be broken down into less complex components. The long call butterfly spread has two parts, a bull call spread and a bear call spread. The following example, which uses options on the Dow Jones Industrial Average (DJX), illustrates this point.

n this example the total cost of the butterfly is the net debit ($.50) x the number of shares per contract (100). This equals $50, not including commissions. Please note that this is a three-legged trade, and there will be a commission charged for each leg of the trade.

An expiration profit and loss graph for this strategy is displayed below.

*The profit/loss above does not factor in commissions, interest, tax, or margin considerations.

This profit and loss graph allows us to easily see the break-even points, maximum profit and loss potential at expiration in dollar terms. The calculations are presented below.

The two break-even points occur when the underlying equals 72.50 and 77.50. On the graph these two points turn out to be where the profit and loss line crosses the x-axis.

First Break-even Point = Lowest Strike (72) + Net Debit (.50) = 72.50.

Second Break-even Point = Highest Strike (78) - Net Debit (.50) = 77.50.

The maximum profit can only be reached if the DJX is equal to the middle strike (75) on expiration. If the underlying equals 75 on expiration, the profit will be $250 less the commissions paid.

Maximum Profit = Middle Strike (75) - Lower Strike (72) - Net Debit (.50) = 2.50.

$2.50 x Number of Shares per Contract (100) = $250 less commissions.

The maximum loss, in this example, results if the DJX is below the lower strike (72) or above the higher strike (78) on expiration. If the underlying is less than 72 or greater than 78 the loss will be $50 plus the commissions paid.

Maximum Loss = Net Debit (.50)

$.50 x Number of Shares per Contract (100) = $50 plus commissions.

By looking at the components of the total position, it is easy to see the two spreads that make up the butterfly.

Bull call spread: Long 1 of the November 72 calls & Short one of the November 75 calls.

Bear call spread: Short one of the November 75 calls & Long 1 on the November 78 calls.

A long butterfly spread is used by investors who forecast a narrow trading range for the underlying security, and who are not comfortable with the unlimited risk that is involved with being short a straddle. The long butterfly is a strategy that takes advantage of the time premium erosion of an option contract, but still allows the investor to have a limited and known risk.

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Butterfly Spread.

The butterfly spread is a neutral strategy that is a combination of a bull spread and a bear spread. It is a limited profit, limited risk options strategy. There are 3 striking prices involved in a butterfly spread and it can be constructed using calls or puts.

Sell 2 ATM Calls.

Long Call Butterfly.

Long butterfly spreads are entered when the investor thinks that the underlying stock will not rise or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower striking in-the-money call, writing two at-the-money calls and buying another higher striking out-of-the-money call. A resulting net debit is taken to enter the trade.

Limited Profit.

Maximum profit for the long butterfly spread is attained when the underlying stock price remains unchanged at expiration. At this price, only the lower striking call expires in the money.

The formula for calculating maximum profit is given below:

Max Profit = Strike Price of Short Call - Strike Price of Lower Strike Long Call - Net Premium Paid - Commissions Paid Max Profit Achieved When Price of Underlying = Strike Price of Short Calls.

Limited Risk.

Maximum loss for the long butterfly spread is limited to the initial debit taken to enter the trade plus commissions.

The formula for calculating maximum loss is given below:

Max Loss = Net Premium Paid + Commissions Paid Max Loss Occurs When Price of Underlying = Strike Price of Higher Strike Long Call.

Breakeven Point(s)

There are 2 break-even points for the butterfly spread position. The breakeven points can be calculated using the following formulae.

Upper Breakeven Point = Strike Price of Higher Strike Long Call - Net Premium Paid Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid.

Suppose XYZ stock is trading at $40 in June. An options trader executes a long call butterfly by purchasing a JUL 30 call for $1100, writing two JUL 40 calls for $400 each and purchasing another JUL 50 call for $100. The net debit taken to enter the position is $400, which is also his maximum possible loss.

On expiration in July, XYZ stock is still trading at $40. The JUL 40 calls and the JUL 50 call expire worthless while the JUL 30 call still has an intrinsic value of $1000. Subtracting the initial debit of $400, the resulting profit is $600, which is also the maximum profit attainable.

Maximum loss results when the stock is trading below $30 or above $50. At $30, all the options expires worthless. Above $50, any "profit" from the two long calls will be neutralised by the "loss" from the two short calls. In both situations, the butterfly trader suffers maximum loss which is the initial debit taken to enter the trade.

Note: While we have covered the use of this strategy with reference to stock options, the butterfly spread is equally applicable using ETF options, index options as well as options on futures.

Commissions.

Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the butterfly spread as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.

If you make multi-legged options trades frequently, you should check out the brokerage firm OptionsHouse where they charge a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies.

The following strategies are similar to the butterfly spread in that they are also low volatility strategies that have limited profit potential and limited risk.

Short Butterfly.

The converse strategy to the long butterfly is the short butterfly. Short butterfly spreads are used when high volatility is expected to push the stock price in either direction.

Long Put Butterfly.

The long butterfly trading strategy can also be created using puts instead of calls and is known as a long put butterfly.

Wingspreads.

The butterfly spread belongs to a family of spreads called wingspreads whose members are named after a myriad of flying creatures.

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