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How to Analyze and Trade a Butterfly

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The butterfly strategy is one of the safer option strategies available to a trader and is well worth learning. The only real drawback is that it involves three separate options at three different strikes, so it is a little more complicated than some other simpler strategies. However, it has the significant advantage that risk is strictly limited.

The essence of the butterfly is a long protective option at the lower strike, two short options at the middle strike and a protective option at the upper strike. Note that the strategy can be used with either puts or calls.

An example using IBM (IBM) calls should be helpful to look at how this strategy works. We will assume we are bullish on IBM although this is not meant as a trade recommendation. If we are bullish we will want our middle strike price to be above the current market level. So we will enter the following trades:

Buy to open 1 IBM November 210 call for $5.20.

Sell to open 2 IBM November 220 calls at $1.37.

Buy to open 1 IBM November 230 call for $0.25.

This will give us a net debit of $271. This amount is the maximum that we can lose. So our risk is strictly limited to this amount. The areas that this option strategy can lose in are below the 210 strike price or above the 230 strike price.

The peak profit point at any given time will be at the middle strike price. The maximum possible profit is $1000 less the $271. However the amount that the position will be worth will continue to grow as time passes because the position has a net theta gain of 0.0134 per day. So we will really be making money while we hold the trade simply through theta burn.

The market risk of this trade is best measured by the net delta. For this spread the delta is only about 0.10 so it has the market risk equal to being long about 10 shares of the stock. The margin requirements are often only the amount of the original $271 we had to put up. However this may vary from broker to broker.

The key to trading this strategy is to try to get out when the stock is at the middle strike price. At that time the profit will be maximized. If the stock goes up or down from there you will be giving back profit. By my calculation there is about a 53% chance that this stock will hit that price during the term of this option.

I call this way of exiting an option trade my stop profit strategy. It is a dynamic way of closing out a trade when the maximum profit level is achieved. By employing this tactic we can actually raise the odds of the getting out at the maximum profit point. Some point out that we have not squeezed the entire time premium by exiting early. That point is true, but is overwhelmed by the fact that if the stock goes up or down from the peak profit point we will be giving money back. Our chance of exiting is the aforementioned 53%. Compare that to a chance of less than 1% that the stock will close at $230 on expiration day.

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At the time of publication, Phil McDonnell held no positions in the stocks or issues mentioned.

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