Butterfly spread strategy, Today I will break down the commonly used options trading a so-called butterfly spread strategy.
It is a very interesting strategy and it can be very profitable.
let us start with the basics: a butterfly spread consists of different options on the same underlying and with the same expiration date.
there are two different butterfly spreads: you can trade either short butterfly spreads or long butterfly spreads.
The main difference is that short butterfly spreads are open for credit and long butterfly spreads are open for debit.
In other words, you get paid for opening a short butterfly spread, while you have to pay for opening a long butterfly spread.
Table Of Contents
- Introduction of butterfly strategy and the benefits of deploying it
- What influences the price of butterfly spread Strategy
- Market assumption of spreads
- The payoff diagram
- The Greeks – Butterfly strategy
- Long Call butterfly spread Example (Autodesk – ticker ADSK)
- Risk of early assignment
- Summary of the key points of the Butterfly spread strategy
Introduction of butterfly strategy and the benefits of deploying it
The short butterfly spread is a different-priced strategy and a long butterfly spread is a balanced strategy.
a long butterfly spread is more or less just a reverse version of the short butterfly spread.
that there are two different butterfly spread variants for both short and long butterfly spreads.
they are both put and call butterfly spreads, between which there are only a few small differences.
All options are puts for put butterflies and all options are called for call butterflies.
Setup: a short butterfly spread
you will need to
Sell 1x In the money put/call
Buy 2x At the money put/call
Sell 1X Out of the money put/call
( if you exchange all the puts with calls you’ll have a short call
butterfly).
Setup: a long butterfly spread
is an inverted version of the short butterfly spread.
Buy 1x In the money put/call
Sell 2x At the money put/call
Buy 1X Out of the money put/call
I will present you the profit and loss of butterflies spreads.
If the price does not move sufficiently, a loss occurs. A maximum loss occurs only if the price of the underlying is exactly at the strike price of the long options.
Long butterfly spreads make a profit when the price does not move much, and maximum profit is made when the price is exactly at the short strike on the expiration date.
If the price of the underlying moves further and beyond one of the long strikes, a maximum loss is incurred.
Butterfly spreads are a defined risk and defined reward strategy, which means that you cannot lose or gain more than a certain amount to understand.
What influences the price of butterfly spread Strategy
I will show you how to calculate your maximum profit, your maximum loss, and your break-even points.
Usually, you do not have to do this yourself, as any good broker should display these numbers on their platform.
The first calculation is very easy to find out.
The max profit (short butterflies) = net premium +/- commissions = Max loss (long butterfly spread )
that calculation is also the max loss of a long butterfly spread with
The next calculation is more complicated you have to find out the.
Max loss (short butterflies) = width of the strikes X100 +/- commissions = Max profit (long butterfly spread )
Let’s present these calculations with an example
long example butterflies spread
Short 95 p/c
Long 100 p/c
Short 105 p/c
premium paid $0.72 or $72
The first calculation is quite simple, the maximum profit for our short butterfly spread is $72. and this is also the maximum loss for the long butterfly spread.
For the next calculation, we first need to determine the width of the strikes.
The difference between the “At the money” strikes and one of the outer options is 5, so the width of the strikes for both spreads is 5.
we need to multiply 5 by 100 and subtract the result with the premium, so $72, the result is $428.
The result is the maximum loss for the short butter flatbread and the maximum profit for the long butterfly spread.
Market assumption of spreads
Both spreads are neutral strategies, but they are different types of neutral strategies.
short-butterfly spreads are estimated in different strategies, which means that it does not matter which way the price moves as long as it moves.
Long-butterfly spreads, on the other hand, are range-bound strategies, which means that the price should ideally stay within a certain price range.
Very tight long butterflies are a rather low probability strategy and short butterflies are a rather high probability option strategy.
The payoff diagram
Short butterfly spreads are profitable as long as the underlying price moves far enough, i.e. the entire price range beyond one of the short strikes is profitable.
That’s a pretty large profitable range, but that’s also the case with long iron condors, even though they are usually a much lower probability strategy.
The reason for this is that short butterfly spreads are usually quite narrow, so the price only needs to move a few points for the spread to make a profit.
In addition, a maximum loss on short butterfly spreads is very unlikely because the price of the underlying asset must be exactly at the strike price of the long options.
In the Long Butterfly Spread, the underlying must move very little for this strategy to be profitable. The maximum profit is also very likely, so the profitable spread tends to be very small with the Long Butterfly spread.
The Greeks – Butterfly strategy
The Greeks measured option price changes for different scenarios.
Short-butterfly spreads respond differently to certain scenarios than long-butterfly spreads.
The long options are the most valuable and therefore the most dominant options for short-butterfly spreads, and this is also the reason why the Greeks are most relevant for the long options.
The long butterfly spreads are dominated by the short options, which are relevant for long butterfly spreads.
Delta
Measures the change in the option price for a dollar moving up in the underline, but since butterfly spreads are neutral strategies, there are both pluses and minuses.
This means that Delta often is just around zero
Vega
Measures the change in the option price when implied volatility increases.
For short butterfly spreads, this means that they benefit from an increase in implied volatility, which is why they should be used in an environment with low IV
To find out how high implied volatility currently is, you should use the IV rank.
IV rank
Compares the current IV of an asset with the status of IV in the past, with an IV rank of above 50 representing periods of high IV and below 50 representing periods of low IV.
You should therefore enter short butterfly spreads when the IV rank is below 50, as Vega is negative.
Long butterfly spreads are the opposite, i.e. long butterfly spreads benefit from a decline in implied volatility.
Therefore, they should be used in times of higher implied volatility when the IV rank is above 50.
Theta
measures the change in the option price over time, which means that the position gains some value each day.
The amount an option loses or gains increases as the option gets closer to expiration. Therefore, time is the worst enemy for short butterfly spreads, as the underlying price has less and less time to move outside the loss range.
For long butterfly spreads, the opposite is true, as the price is already in the profit zone immediately after entry
Gamma
Measures the rate of change of delta for each $ 1 move up the underline.
Positive – means that Delta increases for each move, resulting in a rapid increase in the option price.
Negative – symbolizes that the delta decreases by 1 dollar for each movement.
Gamma also increases the closer the option is to exploration.
Note that all of these Greeks change as these various factors change. If you want to learn a bit more about option prices and the Greeks, I recommend you read my other post about them. Delta and Gamma.
Long Call butterfly spread Example (Autodesk – ticker ADSK)
In this example, we took the underlying asset for the Autodesk ticker symbol ADSK. all strikes are the same expiry date. – expiration date DEC 9th.
Strategy setup: this strategy is constructed from three strike prices.
Buy to open 1 call strike price 197.5
Sell to open 2 call strike price 200
Buy to open 1 call strike price 202.5
Here is what the price graph looks like, we can see that the max loss is under the strike price of 197.5 or above the strike price of 202.5. max profit will occur if on expiration the underlying stock price will be at the middle strike price.
Risk of early assignment
Stock options may be exercised on any business day in the United States, and holders of short positions in stock options have no control over when they must settle the obligation. Therefore, the risk of early assignment is a real risk that must be considered when taking positions in short options.
While there’s no risk of early assignment for long calls in a long butterfly spread, this is the case for short calls. Early assignment of stock options is usually related to dividends. Short calls that are assigned early are usually assigned the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high probability of being assigned.
Summary of the key points of the Butterfly spread strategy
Some tips and a short summary of both strategies
Short Butterfly Spreads are a good strategy in my opinion, mainly because of the high probability aspect.
When setting up butterfly spreads, I recommend not choosing strikes that are either too far or too little out of the money, as this can have a negative impact on the probability of winning credit.
Also, when opening this strategy, you should always take credit, which shouldn’t be too small, otherwise, it won’t be worth it.
As a rule of thumb, I have set $40 as the minimum balance. It is often a good idea to take the profit early rather than wait and hold until expiration, but do not take the profit too early.
Ideally, you should enter this strategy at times of low IV ( 50 ), so use IV rank to help you.
Finally, the probability of a maximum loss is very low, and that makes this strategy even better long butterfly spreads can also be a good strategy.
They are one of many rangebound strategies and I usually like these types of strategies as they often have a high probability of success.
But unfortunately, that doesn’t really apply to long butterfly spreads. I find them too tight for me and prefer a short credit spread or short strangles to the strategy.
But you can increase the probability of winning by making the spread wider. Optimally, one should use this strategy in times of high IV.
This way you can profit from a decline, just as a maximum loss was unlikely with short butterflies, a maximum profit is also unlikely with long butterfly spreads
if you want to learn more about butterfly spreads, other strategies, or trading in general, be sure to check out my other posts, such as: Selling put option for income or Option greeks – Gamma