"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
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.
My current attraction to butterflies is that they provide a low-maintenance strategy with a limited risk/reward profile that isn't altered by a change in implied volatilities. Years ago, establishing a butterfly position was fraught with execution landmines as you tried to leg into a three-part position, leaving a standing order to rot in the cobweb-covered "spread book" controlled by specialists.
Now, though, almost all brokers, certainly those that respect option traders such as OptionsXpress, Schwab's CyberTrader and ThinkorSwim, offer customers one-click order entry for multistrike strategies such as butterflies. And with linkage between exchanges, the likelihood of getting filled at a mid-value or fair-value makes capturing and adding these wonderfully low-cost, low-maintenance positions to your inventory a relatively easy task.
Casting a Net
There are two basic types of butterflies: short and long. The short butterfly involves selling the outside strikes and purchasing the inside strikes. Its maximum profit is equal to the net premium collected, and it is realized if the underlying asset is below the lowest strike or above the highest strike at expiration. The maximum loss is realized if the underlying asset settles at the middle strike and is equal to premium minus short spread.
Professionals are more likely than retail traders to employ short butterflies because by building an inventory across many strikes, the pros can take advantage of pricing relationships by trading off these established spreads.
The maximum profit of the long butterfly is the value of the long spread minus the premium paid, and it is realized if the underlying settles at the middle strike on expiration. This is the position I'd like to focus on.
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 there are less than about three weeks remaining. 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. The right time to establish butterflies is when you believe the market may stay within a defined range. Currently, this can be defined in the
by support at 1140 and the big, bad resistance at the 1200 level.
For example, with the S&P 500 trading at 1175, you could buy the July 1125/1175/1225 butterfly for a net debit of $14 per spread. The 1125 calls can be bought for $63, two units of the 1175 can be sold at $28 each, or a total of $56, and the 1225 call can be bought at $7 per contract. This gives the position a maximum profit of $36 if the S&P is at 1175 at the July 15 expiration. The maximum loss is equal to the cost, or $14, and will only be incurred if the S&Pswings outside the 100-point, or 8.5%, range defined by the 1125 lower strike and 1225 upper strike of the position.
Kick Back, but Don't Fall Asleep
Butterfly positions are often referred to as "vacation positions." They're low cost and have minimum risk; you can establish your position and then forget about it for a while. For most retail investors, there is no need for monitoring or adjustments on a daily or even weekly basis.
Again, as stated above, once the position is within three weeks of expiration, the investor should start to measure the risk/reward of holding the position. As you approach the final four to six days of trading, even if the butterfly is looking on target, the risk/reward of holding out to achieve the maximum profit at expiration becomes a bad bet. A relatively small move of 1% to 2% in the final days could wipe out the profits accrued during the prior five weeks of patience.
While I don't like to present option positions as lottery tickets that produce maximum profit when landing "on the number," the current market conditions suggest there is nothing wrong with scattering a few butterflies and watching the market reveal itself. Maybe a few of those precious creatures will alight on your magic number.
Just invite me to any butterfly-financed barbeques. I like lamb on the chop.
Steven Smith writes regularly for TheStreet.com. 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