The Option Butterfly Spread is one of the best, if not the very best, option trading strategies.
Here is the basic option butterfly trade setup: 1. A vertical debit spread consisting of a bull call spread and a bear put spread. 2. A vertical credit spread consisting of a bear call spread and a bull put spread.
In this option butterfly tutorial post, I’ll give you a detailed explanation of this option butterfly setup along with charts, the 7 kinds of butterfly trades, a put butterfly spread example, benefits of butterfly spreads and why and when to use option butterfly spreads.
It amazes me how little the butterfly spread is used by option traders but I think it seems complicated to most people, so I’ll keep it simple in this option butterfly tutorial post.
Therein lies a golden opportunity to those few individuals willing to spend a little time understanding how to trade the option butterfly spread.
It’s true that the setup can seem overly complicated initially.
I understand. I am the guy who throws out the instruction manual with every single thing I buy that has to be assembled!
But after you get these basic concepts, you’ll see that the option butterfly is just marrying a couple of simple setups that you probably already know.
Keep reading, or grab my 30 page Option Trading Butterfly Tutorial here.
Why The Option Butterfly Spread Is So Powerful
As all traders and investors know, market direction can go through months and even years of higher than usual uncertainty. At times, technical analysis may be painting one picture, while the economic or political environment is painting another.
This can be both stressful and costly. Yet, waiting on the sidelines has opportunity costs. Not only this but for many traders who have come to rely on regular income from trading, loss of that income while waiting out the uncertainty can cause serious lifestyle problems.
Then there’s the random earnings news, political winds, or slightly negative economic factor that can wreak complete havoc on an otherwise perfectly excellent option trade setup. These are all factors way beyond our control that we never even considered when structuring a trade setup that has worked many times before.
We’ve all experienced this!
All of these situations call for a strategy that will work no matter which direction the market or any specific stock heads. This is exactly what the highly versatile butterfly option strategy does.
It gives you a trading advantage in any type of market environment. This makes it a powerful strategy that every serious trader will want to add to their arsenal of skills.
Now there’s no such thing as a free lunch: The Butterfly spread cannot offer unlimited profit potential since built-in risk management structure eats into returns. But butterfly spreads usually cost less than buying options outright for protection while providing a powerful positive risk-reward trade setup that simply cannot be found with other trading strategies.
When to Trade the Option Butterfly Spread
Unlike other option strategies such as iron condors, credit spreads, or debit spreads that only work with an identified objective based on probable market direction, as noted earlier, the option butterfly spread can be set up and traded for a variety of objectives based on where a trader thinks the security or market is headed.
1. Non-Directional – Delta Neutral Butterfly Spreads
You Have No Idea Where the Market is Headed
In their simplest form, butterflies can be delta neutral or non-directional trades. This means they can be used successfully when you simply DO NOT KNOW the market direction.
This is when you would use a trading strategy called a Delta neutral butterfly spread, a strategy that takes the guesswork out of trading. This is particularly advantageous because it can allow you to trade successfully when you would otherwise need to wait for clear market direction.
If you have to wait for market direction, you could be waiting for months. If you trade for a living, this is not an option.
2. Directional Butterfly Spreads
You Feel Pretty Sure the Market Is Headed Up or Down
The directional butterfly spread can also be used for bullish or bearish exposure to the market while also managing risk and retaining large potential returns.
This directional structure is used when you see a high probability of market direction based on technical analysis or other tools.
3. Hedging with Butterfly Spreads
You Don’t Want to Lose Your Shirt!
The directional butterfly can also be used as a fast way to hedge on positions that are moving against you.This is exactly what the most sophisticated trading companies do.
They hedge, and now so can individual traders! Hedging lowers risk when trading, which is something every trader wants.
The Benefits of the Option Butterfly Spread
The benefits of option butterfly spreads are many, as you’ll see below.
Option Butterflies Are Flexible
The option butterfly spread provides flexibility with the ability to alter a previous trade. For example, you can construct an option butterfly trade around a strike that is under pressure from another core trade, such as a credit spread or debit spread.
Use Butterfly Spreads to Buy Time
We’ve all been in those frustrating situations where we just need a little more time for a trade to work out perfectly. Adding a butterfly leg to an existing trade allows you to keep the original position open while buying more time.
Often, additional time is all that’s needed for a trade to move back to profit territory. At that point, you can then remove the butterfly hedge and stick with your original trade.
Option Spreads Are Cheap Risk Management
Risk management is often a necessity for both option traders and investors. Option butterfly spreads provide a low cost way to manage risk.
The low cost of options has for hedging has been noticed and utilized beyond traders. For example, many long term investors and swing traders buy puts for portfolio insurance.
A long term, out of the money, put butterfly strategy, however, can be a much cheaper method of portfolio protection than pure long puts. While no insurance is free, this butterfly trade setup is among the cheapest ways to protect your valuable trading capital.
Butterfly Spreads Generate Income
Butterfly strategies can be used to generate income from stocks that appear to be going nowhere in the short term but are tying up precious time, capital and energy. This can provide more steady income for those who trade for a living.
Not only this, but income also enhances overall portfolio returns in flat markets.
The Risk Reward with Butterfly Spreads Is Fantastic
A 10-to-1 or higher Reward-to-Risk ratio is common with option butterfly spread trades. Where else can this high potential ROI be found?
This unusually high-risk-reward ratio makes it well worth the effort needed to learn how to trade option butterfly strategies.
Butterfly Strategies Are Low Maintenance
Butterfly trades are sometimes called “vacation trades”. You know how you can have a trade open before your vacation which you thought you would have been out of before your vacation arrived?
Then your vacation time arrives. You know you should close out the trade because you don’t know if you’ll have the time, or even the internet connection, to monitor the trade effectively.
But you really, really don’t want to close out the trade because you see the trade can be profitable with a little more time. Butterfly option setups allow you to go on vacation with the trade still open and here’s why: their low-risk profile and need for only very infrequent monitoring.
A word of caution with this: Just make sure the expiration date is not near or during your vacation. (Remember, you can buy time if you need to with another butterfly spread.)
Timing of Butterfly Spreads
Also, remember these tendencies of butterfly spreads.
- Butterfly trades are generally very slow moving early on in the trade
- Butterfly trades get more exciting and volatile as they approach expiration
There’s a lot to understand when trading option butterfly strategies. Keep reading or Get my free Option Butterfly eBook here.
If you prefer video, click the image below to watch a video I did on trading an option butterfly spread with AAPL.
A Few Option Basics You Need to Know First
Now that you’ve seen the reasons that option butterfly trading has a very devoted but small following, you’ll first want to understand a few options basics.
Every option trader should understand Theta, Implied Volatility and Delta. Option butterfly strategies heavily take advantage of time value decay, and the impact it has on the price of an option.
1. Applying Theta to Butterfly Trades
The Theta shows how much an the price of an option will decay over time. Option butterfly trades use this time decay to their advantage.
Without a complete and thorough understanding of how option time decay works, you don’t want to attempt to trade option butterfly spreads.
Hopefully you took a minute to read more about Theta at my article link above and understand its’ importance. For example, take a look at the following chart to see just how predictable and powerful option time decay is!
And look at the time decay noted by the green arrows on the ThinkorSwim® option platform below.
2. Using Implied Volatility for Butterfly Trades
The IV implies the foretasted volatility of the underlying security.
The Implied Volatility is shown under the column labeled Implied Value on the chart below. It illustrates how the time value and Implied Volatility affect the weekly option premium.
Another reason butterfly trading strategies work so well is because they take advantage of this dynamic.
3. Using Delta for Butterfly Trades
The Delta shows correction between the movement of an option price in relation to the underlying security. When trading butterfly spreads, the Delta is used to forecast the probability of a certain price point being reached.
For example, a Delta of 10 indicates there is only a 10% chance of the price of the underlying security to reach a certain price during the related option cycle.
Now that you know the importance of Time Decay, Implied Volatility and Delta, let’s move to how to structure an option butterfly spread.
The Butterfly Setup – 2 Vertical Spreads
The foundation for a Butterfly Spread consists of two parts, a Vertical Debit & Vertical Credit Spread.
Butterfly Setup – Step 1 – Vertical Debit Spread
A Vertical Debit Spread is done for a debit in your trading account. It is structured as follows:
A “bull call” spread entails buying one call and selling a higher-strike call that will be lower in price to offset some of the premium cost and theta decay
A “bear put” spread entails buying one put and selling a lower strike put, that will be lower in price to offset some of the premium cost and theta decay.
The Bull Call Debit Spread portion or “wing” of the butterfly is shown below.
Butterfly Setup – Step 2 – Vertical Credit Spread
A Vertical Credit Spread is done for a credit in your brokerage account. It is structured as follows:
A “bear call” spread entails selling one call and buying a higher-strike call that will be higher in price to hedge the short call.
A “bull put” spread entails selling one put and buying a lower strike put that will be lower in price to hedge the short put. You’ll collect an option premium in your account.
The Bear Call Credit Spread of the butterfly strategy is shown below.
Here are the Debit Spread and the Credit Spread trades summarized in the chart below.
This is the foundation setup for all types of butterfly trades. Let’s look at the 8 different types of butterfly spreads.
Types of Option Butterfly Trades
One major goal of every trader should be to select trades based on what provides the most consistent positive return with low, defined risk. This is not always the trade with the greatest return.
By avoiding the temptation of the pie in the sky trades, traders can succeed with more consistent, lower risk trades.
And one of the best ways to achieve this is using one of the 8 different option butterfly strategies. By understanding the butterfly strategies, you can select the one that is best suited for the market environment you’re trading.
Below are the types of option butterfly strategies. There is a strategy for every trading environment and situation.
- Long Call or Put Butterfly
- Short Call or Put Butterfly
- Broken Wing Call or Put Butterfly
- Unbalanced-Ratio Butterfly
- Broken Wing Unbalanced-Ratio Butterfly
- Directional Butterfly
- Iron Butterfly
- Hedging – Defenses Using Butterflies
Scroll down to continue reading this Option Butterfly Spread tutorial.
Or Download or Share this handy infographic with the 8 types of butterfly trades.
Option Butterfly Trade Example
As you can see from the many variations of Butterfly Option Strategies, it would be difficult to cover all of these strategies in this one post.
What I’ll do instead is provide the exact outline of my favorite Butterfly Option Strategy below.
Long Call or Put Butterfly Spread
This option butterfly strategy is a combination of a bull call debit spread and a bear call credit spread.
Note that it is a limited profit, and limited risk options strategy, as all Butterfly trades are. This is because they contain both an income trade and a risk management trade.
The Butterfly Trade Setup
There are 3 striking prices involved in a butterfly spread. The trade setup can be constructed using calls or puts.
As with all butterfly trades, this trade is called a “butterfly spread” because you are short the body and long the wings. This particular strategy can be used as a neutral or directional options trading strategy.
The charts and the details for this put butterfly spread can be seen below, along with the maximum profit and the maximum loss potential.
As you can see, this trade results in a small net debit (cost) to your account. The maximum risk is the debit paid to construct the trade.
Due to the small net debit, this strategy offers an exceptional risk-to-reward ratio.
This option butterfly strategy capitalizes on being short volatility, and time decay, as addressed earlier in this post.
A target price pinning strategy is also utilized here, as is common with Power Cycle Trading™ methods.
Maximum Profit Potential
The maximum profit for this butterfly trade occurs if the underlying security is at the middle short strike or body at the option expiration.
In this case, the long call with the lower strike would be in-the-money, and all the other options would expire worthless. The profit would be the difference between the lower and middle strike (the butterfly wing and the body) less the premium paid for initiating the position if any.
Maximum Loss Potential
The Maximum loss from this butterfly trade would occur if the underlying security is outside the wings at expiration. The premium paid to initiate the position would be lost.
How to Close a Butterfly Spread
Remember, a butterfly option spread is actually made up of two different spreads, both a debit spread and a credit spread. The short strike of these two spreads is at the same price, which is the body of the butterfly.
At expiration, if any part of the butterfly spread is in the money, that leg should be closed out to avoid being exercised.
Option Butterfly Spread Summary
In summary, the butterfly spread is a powerful way to increase returns while lowering risk. By taking the time to master the option butterfly setup, you’ll gain a powerful edge over others who continue to avoid it.
You now have the option butterfly setup, a butterfly spread example, know the benefits and types of butterfly trades.
If you’d like the content in this tutorial article and important information you need to know before butterfly trading, grab my 30 page eBook on Butterfly Option Spreads below.
Updated June 5, 2019