Butterfly Spread Explained
The first and most basic of the neutral option strategies is the butterfly spread, which is a combination of two vertical spreads. Therefore, it’s important to review vertical spreads before attempting to understand the butterfly strategy. A butterfly spread is primarily used to trade neutral or channeling markets, where the market is trading within an identifiable range.
To take advantage of a neutral market situation, a trader would simultaneously place a trade for a long call spread and a short call spread. The two call spreads must be worth the same, meaning that the difference between strikes must be same for both spreads. By entering a long call spread, a trader is placing a bullish bet, but by placing a short call spread, a trader is entering a bearish position. By trading both sides of the market, a trader is expecting the market to trade within a range that will allow him to take advantage of time decay or theta.
1 Long Call Spread + 1 Short Call Spread = Long Butterfly Spread
In order for the strategy to function as intended, the long call spread and short call spread must share the short strike price. For example, let’s say you form a neutral bias on RIMM (currently at ~$71) and believe that the stock will trade within a range ($70 and $80) during the current expiration cycle and end up around $75 by expiration Friday. In order to enter a butterfly trade, you will now simultaneously enter a long and short call spread.
Taking a look at the option chain, you decide to go long the 70/75 call spread (buy 70 call/sell 75 call) for a debit of $2.25 and short the 75/80 call spread (sell 75 call/buy 80 call) for a credit of $1.24. The cost of the butterfly spread is a net debit of $1.01. **Please take note that both of the call spreads share the same short strike (75 call) and are worth the same amount ($5). This is absolutely critical if you want to construct a butterfly spread. The risk profile of this sample trade is shown below:
From the risk profile, you will notice that by adding a long and short call spread that share the same short strike (strike that you sell), you are able to create a butterfly spread. The spread makes money as long as RIMM trades within a specified range. This range can be determined by calculating the two breakeven points:
Upper Breakeven Point = Strike Price of Higher Long Call – Debit Paid [80 – 1.01] = $78.99
Lower Breakeven Point= Strike Price of Lower Long Call + Debit Paid [70 + 1.01] = $71.01
As long as RIMM ends up between $71.01 and $78.99 by expiration, this trade will make money. But, how much money? The maximum that any of the two spreads can be worth at any time is $5 (difference between strikes), thus if you pay $1.01 for the butterfly, then the maximum you can make will be $3.99 ($5 – $1.01). On the other hand, if RIMM ends up outside of the two breakeven points, then the maximum amount lost on this trade would be the debit.
Max. Profit = Call Spread Value – Debit Paid [$5 - $1.01 = $3.99]
Max. Risk = Debit Paid
Many if not most of the advanced option trading strategies are composed of vertical spreads, thus it’s critical that you understand their makeup and function.
