A butterfly strategy is designed to benefit from an equity staying in a specific price range. This is also referred to as a non-directional option strategy. A butterfly can be applied through the use of call or put options. A butterfly is a neutral strategy which combines a bull spread and a bear spread; this strategy has limited risk and limited profit potential.
For today's purposes, we'll focus on a Long Butterfly Spread. The maximum profit for a Long Butterfly Spread occurs when the stock price remains unchanged at expiration, with only the lower striking call expiring in the money.
Max profit on this strategy is the strike price of the short call minus the strike price of the lower strike long call-net premium paid-commissions paid.
The maximum loss for the long butterfly spread is limited to the initial debit taken to enter the trade + commissions. This occurs when the price of underlying is less than or equal to the strike price of the lower strike long call or the price of the underlying stock is greater than or equal to the strike price of the higher strike long call.
Breakeven - There are two breakeven points for the butterfly spread position:
- Upper Breakeven Point = Strike price of higher strike long call-net premium paid
- Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid
Butterfly Spread Details
Buy 1 ITM Call
Sell 2 ATM Calls
Buy 1 OTM Call
Buy one lower striking in-the-money call and write two at-the-money calls and buy another higher striking out-of-the money call. This will result in a net debit.
Example
CSCO has been trading between a low of $18.35 and a high of $20.49 so far this year. Expecting CSCO to remain at or near $20 by April options expiration (Apr 20th), we'd enter a long butterfly call spread by purchasing an Apr12 19 strike call, selling two Apr12 20 strike calls, and purchasing a Apr12 $21 strike call. The net debit taken to enter the position would be approximately $0.41 for the spread, costing $41 (before commissions).
It should be noted that one downside of a butterfly is the commission expense. For example, if you were to risk $410 on the trade, your commissions to open and close the trade would be approximately $120 (40 contracts x $1.50 per contract to open + 40 contracts x $1.50 per contract to close). Per our given example, your maximim loss on the trade would be $41 for the spread + $6 commission to open the trade.
On expiration in April, if CSCO is trading at $20, the 20 strike call and the 21 strike calls will expire worthless, while the August 19 strike call will have an intrinsic value of $1.00. Subtracting the initial debt of $0.41, the resulting profit is $0.59 per contract or $59, which is also the maximum possible profit. The return would be 143% pre-commission or approximately 114% after commissions.
On this particular trade, on April expiration, the downside breakeven would be with CSCO trading at $19.40 and the upside breakeven would be at $20.60.
Maximum loss occurs when the stock is trading below $19 or above $21 at market close on April 20th. At $19, all the options expire worthless. Above $21, the “gains” from the two long calls will be offset by the “loss” from the two short calls. In both scenarios, the butterfly strategy experiences a maximum loss which would equal the initial debit taken when the trade was entered.
The Butterfly is a tremendous options strategy for taking advantage of sideways markets and/or stocks that typically trade in a tight range.
Trade smart,
The Wiz
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