Butterfly Spread Tutorial for Option Trading

 

The Option Butterfly Spread is one of the best, if not the very best, option trading strategies. Yet this dynamic trading structure is little used by option traders. Here’s why: it seems complicated to most people. Therein lies a golden opportunity to those few individuals willing to spend a little time understanding how to trade the option butterfly spread.

In this article, I’m going to simplify the Options Butterfly Spread for you. It’s true that the setup can seem overly complicated initially. This is because most traders try to master the Butterfly without truly understanding a few basic option trading principles first, all of which you’ll find covered below.

The reality is that once you grasp these basic concepts, you’ll see that the Butterfly is just marrying a couple of simple setups that you probably already know. Serious traders take the time to master the skills to increase their returns while lowering their risk, and the Butterfly is one powerful way to accomplish this. By taking time to master the Butterfly Option Spread, you’ll gain a powerful edge over others who continue to avoid it.

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 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 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: Butterfly spreads cannot offer unlimited profit potential since their built-in risk management structure eats into returns. But they 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.

Now that you know why you want to know how to trade Butterflies, here are the basics that you’ll get in this article.

  1. Best Market Conditions for Butterflies
  2. Benefits of Butterflies
  3. The Option Basics You Need to Know First
  4. The Most Important Option Factor
  5. Types of Butterfly Spreads
  6. My Favorite Butterfly Trade Setup

The Best Market Conditions for 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 – 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. Trying to pick the direction of stocks or the overall market can be stressful and expensive. Delta neutral butterflies can be set up to take 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.

  1. Directional – 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.

  1. Hedging – 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 companies do. They hedge, and now so can individual traders! Hedging lowers trading stress, and who doesn’t want that?

The Benefits of the Option Butterfly Spread

  1. Flexibility

The option butterfly spread provides flexibility with the ability to alter a previous trade. For example, you can construct an option butterfly around a strike that is under pressure from another core trade, such as a credit spread or debit spread.

  1. Time Buying

We’ve all been in 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.

  1. Cheap Risk Management

Butterflies provide cheap protection! For example, many longer-term investors and swing traders buy puts for portfolio insurance. Long-term out-of-the-money put butterflies, however, can be a much cheaper method of portfolio protection than pure long puts. While no insurance is free, this trade setup is among the cheapest ways to protect your precious capital.

  1. Income

Butterflies 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 retirees. Not only this, but income also enhances overall portfolio returns in flat markets.

  1. Risk Reward

A 10-to-1 or higher Reward-to-Risk is common with the Option Butterfly Spread. Where else can this high potential ROI be found? This unusually high-risk-reward ratio makes them well worth the effort to learn the structure.

  1. Low Maintenance

Butterflies are sometimes called “vacation trades”. You know how you can have a trade open before your vacation that you thought you would be out of before your vacation arrived? Then your vacation time arrives, and you know you should close out the trade because you don’t know if you’ll have the time, or even the WIFI to monitor the trade effectively. Bbut you really, really don’t want to close out the trade. Butterfly option setups allow you to go on vacation with the trade open and here’s why: their low-risk profile and need for only very infrequent monitoring. Just make sure the expiration date is not near or during your vacation as shown in the diagram below.

  • Butterfly trades are generally very slow moving early on in the trade.
  • But get more exciting and volatile as they approach expiration and are within the profit tent (Zone).

A Few Option Basics You Need to Know First

Now that you’ve seen all the reasons that the option butterfly spread technique has a very devoted but small following, let me explain the few important basics that you’ll want to fully understand before trading Butterflies. Option measurements use of Greek terms. (Go figure!)

The “Greeks” provide a way to measure the sensitivity of an option’s price to quantifiable factors. The Greeks are strictly theoretical. That means the values are projected based on mathematical models. Why do you want to know this? Because all of the best commercial options analysis packages will provide these excellent option analysis tools for you. On some of the better brokerage sites, they are absolutely free. So, regardless of whether or not you ever trade Butterflies, you’ll want to fully master these concepts if you haven’t already if you trade options at all.

3 Important Greek Tools

You’ll want to be familiar with these Greek terms because they are the terms you’ll see on your brokerage platform when you trade options. I’ll explain each of them in everyday terms and in the paragraphs ahead.

 Theta measures the time decay of an option contract. Time decay happens per day. The rate of Theta, or time decay, increases each day as the option contract approaches the expiration date. Theta is zero at option expiration. The smart option trader uses Theta to his advantage, as you’ll see below.

Implied Volatility is the price movement of an option. The marketplace “implies” what the volatility of a stock will be in the future, and what its effect on the price will be.

Delta measures the price movement of the option contract in relation to a $1 change in the underlying security. An option contact doesn’t move dollar for dollar with the underlying security. By using the Delta, you can see the price movement relationship between the option and the security.

The Most Important Option Factor

The most important factor for successfully trading  the option butterfly spread is the simple concept of TIME and its dynamic effect on the price of an option. Once you fully understand this, you have a huge advantage for successful option trading. Here is why: You can capitalize on the accelerated time decay of an option contract as its expiration date gets closer. This concept is pure gold!

This decrease in option value toward option expiration is called Time Decay. Option Butterfly Strategies heavily take advantage of Time Value, and the impact it has on the price of an option. Remember, you’ll see the term Theta to represent this Time Decay in your brokerage account.

The Value of an Option

To expand on this important concept further, the Time value (also called extrinsic value) of an option is the premium a rational investor would pay over its current exercise value (also called intrinsic value), based on its potential to increase in value before expiring. Note that this probability is always greater than zero, thus an option is always worth more than its current exercise value.

Option Theta Summary

 In summary, Theta tells you how much an option’s price will diminish over time, which is the rate of time decay of a stock’s option. This time decay occurs because the extrinsic value, or the Time Value, of options diminishes as expiration draws nearer. By the option expiration date, options have no extrinsic value and all Out of the Money (OTM) Option expires worthlessly. The rate of this daily decay all the way up to its expiration is estimated by the Options Theta Value.

As you can see, understanding Theta is extremely important for the application of option strategies that seek to profit from time decay. You can think of Theta as a measurement toward winning trades.

Options Theta Characteristics

Let’s expand your knowledge of this important concept further. Option Theta values are either positive or negative.

All long stock option positions have negative Theta values, which indicates that they lose value as expiration draws nearer.

All short stock option positions have positive Theta values, which indicates that the position is gaining value as expiration draws nearer.

Theta value is highest for At-the-Money (ATM) Options, and progressively lower for In-The-Money (ITM) and Out-of-The Money (OTM) options.

ITM and OTM options have much lower extrinsic values, giving little left to the decay.

An Example of Theta

An option contract with Option Theta of -0.10 will lose $10 per contract every day even on weekends and market holidays.

This means that the buyer/holder of an option contract over a 3-day long weekend with a price of $1.40 or $140 per option contract and an option theta of -.10 will find the price of that option at $110 instead of $140 after the 3-day weekend! Ouch!

Theta Decay Strikes!

Option Theta does not remain stagnant. It increases as expiration draws nearer and decreases as the options go more and more In-The-Money or Out-of-The Money. In fact, the effects of Option Theta decay is most pronounced during the final 30 days to expiration where Theta soars.

Take a look at the following chart to see just how predictable and powerful this option paradigm is!

How Option Pricing Works

The formula to value an option is below. As you can see, this formula pulls together all of the elements you’ve read about in this article. Once you know these variables then you are ready to price an option and know what its option premium should be. You can imagine how valuable this knowledge is.

Time Value (x) Implied Volatility (x) Intrinsic/Extrinsic Value

The Butterfly Foundation – Vertical Spreads

Now that you have completely grasped the important concept of Time Decay, let’s move to the structure of an Option Butterfly Spread. This is outlined below.

The foundation for a Butterfly Spread consists of two parts, a Vertical Debit & Vertical Credit Spread

A Vertical Debit Spread is done for a debit in your 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.

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.

Below is a diagram of a Vertical Bear Call Credit Spread.

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. Traders must learn to avoid the temptation of the pie in the sky trade, so they can learn to love more consistent, lower risk trades.

And one of the best ways to achieve this is by knowing the Option Butterfly Strategies that are available, how they work, and then selecting the one that is best suited for the market environment you are trading.

Below are the variations 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

Favorite Butterfly Trades & Hedging

As you can see from the many variations of Butterfly Option Strategies, it would be difficult to cover all of these strategies here. What I’ll do instead is provide the exact outline of my favorite Butterfly Option Strategy below.

Long Call or Put Butterfly Spread

This 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 an income element and a risk management element.

There are 3 striking prices involved in a butterfly spread and it 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.

This trade results in a small net debit to your account. The maximum risk is the debit paid to construct the trade. Due to small net debit, this strategy offers an exceptional risk-to-reward ratio.

This strategy capitalizes on being short volatility, and time decay. A target price pinning strategy is also utilized here, as is common with Power Cycle Trading™ methods.

Maximum Profit Potential

The maximum profit 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 wing and the body) less the premium paid for initiating the position, if any.

Maximum Loss Potential

The Maximum loss would occur if the underlying security is outside the wings at expiration. The premium paid to initiate the position would be lost.

In summary, Option Butterfly Strategies offer many benefits over other option trading structures. Once you understand the important concept of Time Value, you’ve got the most important element of options trading. There is one foundation setup for Option Butterfly Strategies which has many variations that can be applied to different market environments and goals. If you want to learn more about butterfly trading, be sure to get my eBook here with the information above and much more.

 

Larry Gaines has become one of the leading coaches for successful traders and investors. He continues to develop and host, every month, new trading educational programs to help traders and investors generate greater income from their investment capital with less risk exposure. 

He founded PowerCycleTrading.com and the Power Cycle Virtual Trading Room following over 30 years of professional trading experience in the commodity and equity markets. 

 During his tenure as head of an international trading company that often traded a billion dollars’ worth of commodities in a single day, he learned first-hand the necessary elements of a successful trading system and the use of options.

Using this in-depth knowledge and experience, Larry developed the Power Cycle Trading™ Model to allow for greater profits with a more disciplined, systematic degree of trading success.

Disclaimer

The following is purely for educational purposes. Any stocks mentioned DO NOT constitute advice and should NOT be construed as recommendations.

U.S. Government Required Disclaimer – Commodity Futures Trading Commission. Futures and options trading has large potential rewards, but also has large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don’t trade with money you can’t afford to lose. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this website. The past performance of any trading system or methodology is not necessarily indicative of future results.

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