Introduction to Options Trading – Part 2 – Options Strategies: Butterfly Strategy

In the last Options Trading blogpost (Introduction to Options Trading), we looked at the basics of options trading: what does options trading mean and I’ve explained a few examples how you can trade options. If you are new to options, please start from part 1 here.

In the next few weeks, I will cover some of the best options strategies that works for me.

In this post, we will specifically look at Butterfly Options Trading Strategy. Please note that this is by no means a complete strategy guide for options or butterfly type of trades, just the strategies that I utilise when trading options. Again, this doesn’t mean that these are the best strategies in options, just take them as new tools in your trading toolset.

Butterfly Options Strategy

This is an advanced ‘neutral’ options strategy that requires you to find stocks that trades in a very tight price range. When I utilise this strategy, I look for stocks with a change of 5% for the last 3 months and shows similar type of price change in the last 12-18 months. You also need to make sure there are no major news or results are expected before the expiration date (so there is no big change in the price of the underlying stock).

A typical butterfly trade, consists of at least 3 options trades to be done at once. Just like statistical arbitrage trades, this means that you will lose in two options trades and win in one option trade. As you rightly guessed, your winnings should be higher than your two losses to make money on this strategy. Also note that, both your risk and reward are limited in this type of strategy.

Let’s look at an example, as below.

LONG Call Butterfly Options Trade Example

MonacoTrader (MT) finds a good candidate stock (XXX) for a Long Call Butterfly.

Stock XXX – Today’s (DEC) stock price: $100

MT enters a Long Call Butterfly by purchasing a JAN 95 CALL for $11 per share and sell x2 JAN 100 call for $4.50 per share, and buys JAN 105 call for $0.80 per share. (you will remember from part 1, there are 100 shares in 1 option contract).

So just to summarise:

when I buy 1 Contract JAN 95 CALL, I pay $11 x 100 = $1,100 (needs to be paid immediately to the broker to cover the purchase)

When I sell 2 Contracts JAN 100 CALL, I pay $4.50 x 200 = $900 (will get paid immediately to your brokerage account as you sold them)

When I buy 1 Contract JAN 105 CALL, I pay $0.80 x 100 = $80 (needs to be paid immediately to the broker to cover the purchase)

MT’s Gross Cost:  $1,100 – $900 + $80 = +$280

Now I know that my maximum possible total gross loss in this trade will always be $280. The trade will be a loss only if the market price of XXX was above or below the max loss point at the JAN Expiration date.

In other words, the net premium paid at open is the maximum possible profit that the investor can gain from this strategy, and the difference between the net loss reaped between the long and short calls or puts minus the initial premium paid is the maximum possible loss that the investor can incur as shown in the example above.

The maximum profit on a Butterfly Spread is at our Short Strike, in the example above, it is the 100 Strike. In some Butterfly Spreads, the maximum profit at expiration can reach over 250% (waiting for this comes with its own risks!) but I generally only hold Butterfly trades for 15 to 21 days, and then exit. If all goes well, expect to exit with a handsome profit of 10% to 20%. Of course if you wish to hold it to the expiration date, you can. But any news or major event can change the price of the stock dramatically and it can turn into a loss!

Another way of looking how to profit on a Butterfly Options trade is through the reduction of Time Premium of our Short positions during the 15 to 21 days period. Since one of our Long positions is ‘In The Money’, almost all of the cost of that Option will be ‘Intrinsic value’. However, the amount that the position is In The Money, the value of our Short Positions, will be almost all Time Value. As we get closer to Expiration, we will be able to sell our Long positions for about what we paid for them. However, it will cost us less to buy back our Short positions, and we end up with a profit. In essence, we buy the Butterfly at a low price, and then sell to close it later at a higher price.

For those of you using Interactive Brokers (IB), they have a quite a good (but not excellent) Options Strategy Builder comes with their TWS. It is relatively easy to use tool where you can create spreads and analyse potential profit, exit, break even points. You can also create multi-legs for even more complex options strategies. I suggest you try and see yourself.

My Ultimate Trade Setup for Butterfly Option Trades:

Time to enter the trade: 35 days until 25 days prior to expiration

News: There are no major news or expected, no earnings news, no mergers or acquisitions, no major sector movement for the chosen stock.

Time in Trade: 15-21 days. You can hold it until expiration if you wanted to (perhaps waiting for expiration and not take the profits when available is riskier strategy)

Stock Price: At least $60 or above – If the price is underlying is too low then the price of the options will be too low. Hence the potential profits will be low.

Summary QA

Q: When should I use this strategy
A: When you think the price of the underlying stock will be stagnant or will change very little before the option expiration date.

Q: What are the advantages of Butterfly Options Strategy?
A: 1) Good profit potential with low cost entry 2) Risk and Reward parameters are set before entering in the trade 3) Quite a large number of underlying stocks can be found to utilise this strategy.

Q: What are the disadvantages of using Butterfly Options Strategy?
A: 1) Depending on your broker, larger commissions might be applicable to these type of trades 2)This strategy is more appropriate for experienced traders who can watch the markets during trading hours and thoroughly understand the potential risks and rewards involved.

I hope this helps. Let me know your comments or questions on twitter (@MonacoTrader).

Have a nice weekend.

MT

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