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The butterfly strategy is one of the best ways to trade an expected sideways or neutral market outlook. The peak profit of the strategy is achieved at the central strike price of the technique. Let us first define what a butterfly is and then talk about how to trade it.
A typical butterfly might consist of the following trades.
Buy to open 1 February 80 call for $7.30.
Sell to open 2 February 87.5 calls at $1.81.
Buy to open 1 February 95 call for $0.09.
Note that this is not intended as a recommendation, rather a discussion of the strategy. The peak profit will be reached at the middle strike price of 87.5. Assume the stock is currently trading at about $86. Any possible loss will be strictly limited to the net debit we have paid to enter this position.
Our exit strategy will be to simply wait until the middle strike price is reached on the stock. So when the $87.50 stock price is reached we will be at the highest profit on the option strategy. Any move, either up or down from there will be detrimental to the option position. So as long as we have a reasonable profit in the position we will use our stop profit strategy to exit.
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