Skip to main content

The worry about a war with Iraq is spurring a wide range of activity: Saddam Hussein is trying to hide his weapons, the U.S. is amassing its troops, certain European countries are complaining, and I'm urging investors to go collect butterflies.

Maybe you're not one for nature walks, so let's get to the point. I have no idea where the markets are going before the war, after the war, or if there is no war.

But what I do see is an opportunity to build an inventory of options positions from which future profits may be generated, regardless of the market's direction. One way you can do that is with a butterfly spread.

What It Is

A butterfly is a three-strike position, involving the sale (or purchase) of two at-the-money options, while simultaneously buying (or selling) one out-of-the-money and one in-the-money. All the options will have the same expiration.

Here's an example. Assume shares of XYZ are trading at $55. A long butterfly would be:

Long one $50 call or put.

Short two $55 calls or puts.

Long one $60 call or put.

A short butterfly would involve going long (buying) the middle strike. Though both approaches are closely related in terms of providing a limited risk/reward profile, this article will be focusing on the long butterfly.

The maximum profit of a long butterfly is achieved if the underlying security settles at the middle (short) strike at expiration. For the above example, that would be $55, meaning that the long $50 call would be worth $5, and both the $55 and $60 would expire worthless.

TheStreet Recommends

For Bull or Bear

A good way to think of butterflies is as a strategy that combines two vertical spreads, one bullish and one bearish, with a common middle strike. Given that current levels of volatility are high, a situation has been created where positions in

S&P 500

out-of-the-money options can be established for even money or a small net debit.

The great opportunity here is that for little or no cost, one can build an inventory of bullish and bearish spreads. No market prediction is necessary. Just put them on and see where the index lands come expiration day.

Let's let look at an example based on prices at midday on Monday with the S&P trading at 835. The table below shows the April 850, 875 and 900 long call butterfly.

This is a very conservative position in that the maximum loss is limited to the net debit, or in this case just $1 per spread. But the maximum profit is $24 if the S&P stands at 875 come expiration on April 19.

A similar position can be established using April out-of-the-money puts.

This is essentially a bet that the index will land at 750 on April 19. Again, the risk is limited to your cost, and the maximum profit is the strike differential minus your cost.

An important pricing dynamic of the butterfly position is that its theta, or price sensitivity to time decay, accelerates significantly as the expiration date approaches. That means the spread's value (and delta) will remain relatively constant regardless of the underlying asset's price movement until about less than three weeks remain.

At that point the position becomes increasingly sensitive to price movement. It also means that maximum profits can't be realized unless the position is held until expiration.

As a result, butterfly spreads are typically employed by professional options traders rather than individuals. Professionals will sometimes establish a large inventory of these low-risk spread positions and then make swing trades against them.

While I don't like to present option positions as lottery tickets that need to land on the number, the current combination of no clear market direction and the ability to establish the positions for little net cost or risk makes butterflies a beautiful opportunity for individuals as well.

Steven Smith writes regularly for In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

Steve Smith.