Unbalanced Butterfly: Tilting the Odds

You're on your way to the airport to catch a flight when the inevitable happens. You’re stuck in traffic. Your anxiety level elevates and your mind starts racing. Do you take an alternate route, stick with the slow traffic, or let it go and be content with missing your flight? As an options trader, you know the value of time. When your contracts’ expiration date gets closer and your positions aren’t doing much, do you let them expire worthless, or do you modify your positions? Unlike a traffic snarl, with the market you have more choices. One strategy to consider is the unbalanced butterfly. Perhaps you’re already familiar with the butterfly and iron condor. And you may have heard they can in fact be “unbalanced.” But what makes them that way? How does it change the strategy? And how do you manage them?

First, The Fly: Remembered

To refresh, a butterfly combines a long vertical spread and a short vertical spread assuming the following conditions:

• The options are the same type (all calls or all puts). 

• Each of the vertical spreads must have the same distance between strikes. 

• The short option in the long spread and the short option in the short spread must share the same strike. 

• All options must have the same expiration date.

Put this all together, and your profit curve will look like Figure 1.

Because the two spreads in the butterfly share the same short strike, it follows that the spread you buy is always more expensive than the spread you sell. Therefore, the trade is always put up for a net debit.

Yet, there can be two problems inherent to the butterfly. First, because it is a threelegged trade, commissions can be much greater than with other strategies, making it potentially expensive. Second, it’s often difficult to pinpoint a max profit because it can only be reached at one price, which is highly improbable. This is where an unbalanced butterfly may help.

Unbalanced: Butterflies For Credits

Rather than place a trade for a net debit, the unbalanced butterfly allows you to modify the original trade so you can place it for a net credit. Then, if the trade doesn’t work out, there’s a chance you’ll still get to keep that credit for your troubles. Unbalanced butterflies include an extra short call or put vertical, even though you may not see it. They’re sold at the strike furthest out-of-the-money (OTM) and the goal is to sell enough premium in the second vertical to place the trade for a credit. Now you’ve increased the potential profit, but you’ve also increased the risk. And, you’ve added a vertical layer you need to monitor and manage. Your new profit curve would look like the trade in Figure 2.

FIGURE 1: CLASSIC LONG BUTTERFLY. Nothing fancy here but a combination of a long vertical spread and 

short vertical spread of the same type. Great for sideways markets, but tough for traders to pinpoint a profit zone. 

For illustrative purposes only.

FIGURE 2: SEE? IT'S TILTED. Adding that extra vertical layer shifted the risk curve of the long butterfly. There’s

potentially more risk along with greater profit potential. For illustrative purposes only.

What's the Catch?

Unlike the standard butterfly where your maximum loss is limited to the debit you paid, with an unbalanced butterfly, your risk is limited, but possibly much greater than that small debit. To illustrate, consider the following example:

Suppose you’re looking at OTM butterfly trades on stock XYZ, currently trading at $115 per share. Maybe you’re bearish and think there’s a good chance the stock can settle around $95 per share at expiration. So you decide to buy the 100-95-90 put butterfly expiring in about two months.

Suppose you can place this trade for a seven- cent debit, excluding commissions. That may not sound like much. But then again, you’re asking for a price target $20 away from the current stock price. While the planets may align for you, and the stock could land at $95 at expiration, the more likely outcome is that the trading gods will keep your seven cents and leave you with nothing.

What if you modify your trade from a net debit to a net credit? Instead of trading the 100-95-90 put fly, you “skip” a strike, and trade the 100-95-85? Turns out the trade can in fact be placed for a net credit of two cents, excluding commissions. This may not seem like a big deal. But for a trade that has a high probability of not realizing its maximum profit potential, getting your two cents’ worth may be a decent compromise.

Even if you put on the unbalanced butterfly as one trade, it’s helpful to look at it as a butterfly plus a short vertical. That way, you can monitor the price of that extra short vertical, potentially buy it back for a profit, and leave the butterfly on.

Remember your original trade was the 100-95-90 put butterfly. That trade can be broken down into one long 100-95 put vertical and one short 95-90 put vertical. Put another way, you have one long 100 put, two short 95 puts, and one long 90 put.

To create the 100-95-85 unbalanced butterfly, you add a short 90-85 put spread (said another way, you sell a 90-85 put spread).

Here’s how the math works out: Notice how the long 90 put and the short 90 put cancel each other out? You now have an unbalanced butterfly, in which the two long strikes are no longer the same distance from the center strike. The furthest OTM option, the 85 put, is less expensive than the 90 put you used to be long. Because you didn’t pay as much for the furthest-out long option (often referred to as the “tail”), those savings were passed on to the cost of your trade, leaving you with a net credit.

There's Just One Thing …

By moving your furthest OTM strike $5 further out, you’ve created a gap in your protection. Your trade can now lose more than the entry price. In this case, your trade still has limited risk, but while the risk in your original butterfly was limited to the seven-cent debit, the risk in your new unbalanced butterfly is limited to the extra $5 of difference in strikes that you added, less the two-cent credit, for a total potential risk of $4.98.

That may seem like a large change. But if you look Figure 3, you’ll see that the stock would have to drop from $115 (its present price) to $85 per share or lower to realize a max loss. You can see the risk profile of your unbalanced butterfly on the thinkorswim^® platform by TD Ameritrade from the Analyze tab. Create a simulated unbalanced butterfly trade, then click on Risk Profile.

Managing the Embedded Vertical Spread

At some point, you may decide it’s no longer worth having the additional downside risk created by an unbalanced butterfly. As time passes, if the stock doesn’t drop below $90 per share, time decay (theta) works in your favor. If the 90 puts and the 85 puts are still fairly OTM, you may find that both options are close to worthless.

At this point, you may opt to buy back that 90-85 put spread that is embedded in your trade for a profit. That would bring you back to a 100-95-90 butterfly, and your overall risk would be considerably reduced. Alternatively, if the 90 and 85 puts are near worthless, you may simply buy back the 90 put. This would have the same effect of limiting your risk, except you’d still be long the 85 put as a sort of lottery ticket.

The Future: Flying Cars

Unbalanced butterflies can change the landscape for traders looking to shift risk further away from a prevailing stock price. You may decide you need a trade with more or less time to expiration. You may seek a considerably larger net credit. This is all part of knowing your style, and trading within your comfort level.

As you continue to grow as a trader, you may want to explore unbalanced trades where you change the ratio, rather than the difference between the strikes. For example, instead of a butterfly with a 1-2-1 ratio, you may decide to sell a vertical spread using the option strikes already within your trade. This may change your trade ratio from a 1-2-1 to, say, a 1-3-2. Finally, if you’re more of an iron condor trader, you may want to consider unbalanced condor trades. The possibilities are endless, but at least now you know where to begin. And take road rage out of your options.