Butterfly Season in Options Land

"Do not touch nothing. The truth will be revealed by the facts as they exist."

This was Hercule Poirot's first and essential order for solving the Murder on the Orient Express. It seems equally applicable for frustrated options traders, who find themselves increasingly confounded by the current market mystery and searching for ways to make a profit. The clues include gyrating stock prices, a stubbornly active Federal Reserve in the face of a slowing economy and the fact that the major indices appear to be finding a home smack in the middle of their wide, five-week range.

Poirot's approach of establishing an objective, static position from which to best observe the underlying moving parts is much like an options trader's use of the butterfly spread. A butterfly is a three-strike position that involves the sale (or purchase) of two identical options, together with the purchase (or sale) of one option with an immediately higher strike, and one option with an immediately lower strike.

All options must be the same type and have the same expiration date. One way to think of butterflies is as a combination of two vertical spreads, one bullish and one bearish, with a common middle strike.

Don't Fear Getting Butterflies

This strategy's name undoubtedly is derived from its structure of a midsection and two equidistant outside pieces, which creates a profit-loss diagram that has two "wings." Being a bit of a romantic, however, I like to think that it refers to a position that starts off as essentially neutral and, without the trader's touching it during most of its lifespan, has the potential to emerge as a beautifully profitable position.

Whatever its etymology, the term can be intimidating to some investors who believe the butterfly spread is a complex strategy best left for professional or sophisticated traders. This belief has some basis in reality, because a multistrike position can force retail investors to head into the treacherous.