Spring is the Time for Butterfly Spreads

While big trades are common in Nasdaq 100 unit trust (QQQ Quote - Cramer on QQQ - Stock Picks) options , there was one huge transaction earlier this week that grabbed some traders' attention.

On Wednesday afternoon, a major investment bank executed a butterfly spread in QQQ options, buying 50,000 April 55 calls and 50,000 April 69 calls and selling 100,000 April 62 calls. The QQQ traded in a range from $48.97 to $50.43 and closed at $49.42 on Wednesday, the day the butterfly trade took place.

What the heck is a butterfly spread? And why the heck should you ever use one?

For help in explaining the trade and its possible outcomes, we turned to the folks at the Options Industry Council for some insight.

A butterfly spread is constructed using a series of three options with the same expiration and an equal distance between the strikes. The position consists of two options at the middle strike (the body) against one option at each of the outside strikes (the wings), so a single position would be long two options and short two options. The value of the wings will always exceed the value of the body, so to buy the butterfly means buying the wings and selling the body.

In this trade the investment bank bought 50,000 of the 55-62-69 April call butterfly at a price of $1, so the total transaction value was $5 million (debit multiplied by 50,000, multiplied by the number of shares in each option contract). The price is usually negotiated for the butterfly as a whole and then individual prices are arbitrarily assigned to each of the components so it adds up to the net debit/credit.

The maximum profit for this butterfly will be achieved if the QQQ is trading at 62 when the options expire. In that case, the 55 call would be worth $7 and the other strikes would be worthless (62 calls at the money and 69 calls out of the money ), so the investor would have earned $30 million on an investment of $5 million.

If the QQQ is below 55 at expiration, all the calls would be worthless, so the position's value would be zero. If the QQQ is above 69, all the calls would be in the money and the position's value would again be zero (long at 55 and 69, short twice at 62). As long as the QQQ is between 56 and 68 at expiration, the position will be profitable.

As a short-term play, this position would seem to have limited potential, but if held to expiration and if the QQQ actually trends up to 62 at expiration, the payoff would be substantial. That situation would present the investor with a dilemma, however, because there would be no way to know for sure whether or not he or she would be assigned on the short 62 calls.

If the investor assumed, when the QQQ closed at 62 on expiration Friday, that he or she would not be assigned, and then got an assignment notice on Monday morning, the investor would be exposed to QQQ gapping up over the weekend.

For that reason, most investors who play spreads like this butterfly prefer to use cash-settled options and avoid the complexities of exercising something with an underlying security.