Editor's note: In this week’s Swim LessonsSM column, Scott Connor explains the basics of the Butterfly option strategy. TD Ameritrade clients can join a free, live educational session on Butterfly Mechanics and Utility by joining Swim LessonsSM in the thinkorswim platform® on Wednesday June 21st at 10:30 AM CT.
In a recent Swim Lessons article, we looked at how the buying and selling of vertical spreads can be used for directional trading. We also looked at how we can put together two short out-of-the-money vertical spreads to come up with a high probability non-directional trade for markets that may be range-bound. That’s the iron condor.
A butterfly spread, while similar in nature, is just the selling of two options at one strike and the buying of one of both a higher and lower strike option of the same type (i.e. calls or puts). And if you understand how the iron condor works, then you’ll see that buying a butterfly is similar in principle to selling an iron condor.
The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation. Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.
Comparing These Two Winged Creatures
Remember: an iron condor is a combination of both a short out-of-the-money (OTM) put spread and a short OTM call spread. The combined premium from both short vertical spreads is the maximum potential profit. But since only one spread can be in-the-money at expiration, the risk is the width of the spread minus the combined premiums. As long as the underlying doesn’t move much and both spreads remain OTM at expiration, all is well.
The butterfly is also just a combination of two vertical spreads. But whereas the iron condor is made up of one call spread and one put spread, the butterfly is made up of either two call spreads or two put spreads.
And instead of looking for both OTM spreads to expire worthless, the butterfly wants one spread to go out worthless, and one spread to be worth its full value. Here’s how it works.
Let’s say we have a stock that’s trading at or below $50, and we think the stock is going to drift up to $50 over the next month. Buying a 47 call and selling the 50 call as a spread (the “47-50 call spread,” in trader lingo), in an expiration date that’s about one month out, is a bullish trade that’s worth its maximum value if the stock closes at $50 or higher at expiration.
But suppose we don’t think the stock is going to move much higher than $50. With that view, we might consider selling the 50 call and buying the 53 call, as a spread (the “50-53 call spread”), which is a bearish trade whose max profit is realized if the stock stays below $50 through expiration. Put the two trades together and you have a multi-legged spread with the potential for max profit if the stock were to close right at $50 at expiration, as shown in figure 1.
Doing the Math
This combination of long and short vertical call (or put) spreads is a butterfly. The neat thing about it is that the premium from the short vertical helps to offset the cost of the long vertical, netting out a lower premium paid and therefore a lower risk. But it’s worth noting that multi-leg spreads will incur more transaction costs that single-leg options.
For the sake of simplicity, let’s assume the following transaction prices (each near mid-market per the bid/ask in figure 1):
Buy a 47 call at $3.40
Sell two 50 calls at $1.20 each
Buy a 53 call at $0.20
With these prices, the 47-50 call spread would cost $2.20, but selling the 50-53 call spread would bring in $1.00, for a total cost of $1.20 for the butterfly (plus transaction costs), and that’s your maximum risk. If the stock drops below $47, or jumps above $53 at expiration, you’ll hit the maximum loss.
Remember, the multiplier for most standard listed U.S. equity options is 100. So, in dollar terms, the spread costs ($1.20 x 100) = $120. And let’s not forget about transaction costs. Multi-leg spreads generally mean larger transaction costs, including multiple commissions.
If the stock finishes right at $50, you would hit the maximum profit, which is the difference between the strikes, minus what you paid, plus transaction costs. In this case, the long in-the-money 47-50 call spread would be worth the full $3, and the short OTM 50-53 call spread would expire worthless. And since you paid $1.20 for the spread, your net profit before transaction costs would ($3 - $1.20) x 100 = $180.
A Final Word on Butterflies and Iron Condors
Butterflies, especially those with out-of-the-money strikes can come in handy around earnings season, or any time you might expect a stock to move quickly into a range and then sit there.
For example, suppose a stock is trading at $100 a share, and you expect an earnings surprise that will take it to $110. Buying a butterfly with 110 as the middle strike, say the 105-110-115 call butterfly, can be a capital-efficient way to take advantage of an anticipated move. Of course, if the stock stays below $105, or if a surprise upside move takes it above $115, you’ll lose the premium you paid for the spread, plus transaction costs.
Iron condors and butterflies are sort of in the same family, and have similar risk profiles. They’re both made from a combination of two verticals, and both can be used when you expect a stock to stay within a certain range. But there are some key differences, which we’ll explain in an upcoming article.
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