Many traders are afraid to trade a butterfly spread. My goal today is to dispel that apprehension and help traders understand this low risk high potential technique. We will use

Broadcom

(BRCM)

as our practical example. Because I am bullish on the stock we will set this up as a modest bullish play with very low risk.

BRCM is trading at $44.18 at about 1:45 p.m. EST, so we will select the following butterfly just above market.

Trades: Buy to open 1 BRCM February 45 call for$2.76, sell to open 2 BRCM February 46 calls at $2.33 and buy to open 1 BRCM February 47 call for $1.91.

The net debit is $0.01.

Butterflies are characterized by buying one option at a low strike price (45), selling two at the middle strike (46) and buying an insurance option at the higher strike (47). The entire amount at risk is the net debit of $0.01. Clearly this is a low risk strategy, but it can be valued up to the difference if the strike prices of the two lower strikes, which is to say $1.00 in this case. The peak profit will always be reached when the stock is trading at the middle strike price. However the peak value at any given time will be somewhat less than the $1.00 figure depending on how much time value is left in the options.

These prices were selected by using the current bid/ask spread and then adding $0.01 to the bid, if buying or subtracting $0.01 from the bid if selling so as to become the most competitive quote on that side of the option. Traders should use limit orders and try to capture a little of the market maker's spread. As always the individual prices are not important; rather traders should focus on the overall net debit.

As readers of my articles know we will use a stop profit strategy and exit anytime the stock reaches the middle strike price of 46. The reason is that butterflies reach their peak profit at that point and any further price movement will give profit back. The probability that the stop profit will be touched at some point during the life of this spread is 77% so it is quite likely that we will get out at the peak. But traders who stubbornly hold to expiration should consider that the probability that the stock will still be in the $45-$47 profit zone at expiration is only about 15%. That is a very compelling reason to maintain our stop profit discipline.

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

Phil is a professional options trader and contributes regular commentary to the Daily Speculations web site. Prior to trading professionally, Phil was a software developer for Dollar/Soft, a financial software company specializing in options software for equities, indexes and futures. He also wrote the book, Optimal Portfolio Modeling, which was published by Wiley Trading in February 2008.

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