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photo credit: gentlebird
When some option traders look at the risk graph of a butterfly - or the butterfly spread payoff diagram - they can’t understand why anyone would want to trade these things.
When you look at a risk graph representation of the butterfly trade - it can look improbable that the underlying will remain within the profit range that is provided. If you have ever seen one - the payoff diagram resembles somewhat of a narrow triangle - or an Indian tepee. The range that resides ABOVE the zero - or break even line - is actually quite narrow - especially when compared to the huge width of a higher probability Iron Condor.
While admittedly the range is narrow - and the probabilites can be quite high that the underlying will break through one of the two sides of the initial risk graph - there are things about the butterfly that more than compensate.
For one - if the underlying DOES stay with in the range - which it certainly can - the profits one can take out of a butterfly is HUGE compared to what can be taken out of a higher probability condor. 20, 30, even 40 percent is not unheard of.
Another thing is that the profits can be realized much faster in a butterfly trade because of the way they are constructed with that narrower width.
Third - the amount of premium that a butterfly trade holds in that ‘tepee’ can become very useful in funding the management and adjustments of the trade if it’s needed - allowing a butterfly trader to potentially stay in a trade much much longer than an iron condor might be able to with limited built into the trade resources to ‘weather’ a wild market storm.
Technorati Tags: butterfly options, Butterfly Spread, butterfly spread payoff diagram, butterfly trade, Credit Spread, Iron Condor
photo credit: BozDoz
The short strikes of the butterfly spread are usually sold ATM (at the money). Strikes that are at the money have the most ‘Time Premium’. Time premium is what will erode away making the butterfly spread trader / option seller money.
Butterfly spreads are 3 legged trades. Again, the short strikes are sold at the money - and the wings are purchased in equal distance apart from the shorts. One could think of the butterfly spread as the sale of a straddle - with a strangle purchased around it.
Sometimes, if the underlying isn’t sitting exactly at a strike price at the time a butterfly trade is placed, the trader could place a ’split strike’ butterfly - where the short legs of the trade are sold at two strikes next to each other - or very near each other.
For example, lets say that a trader wishes to place a trade on SPX when SPX is trading at 997.
Because SPX is trading almost exactly between the only available strikes (995 and 1000) it might make more sense to the trader to place a split strike butterfly to help in keeping closer to delta nuetral.
A split strike butterfly in this example would look something like this:
Buy 1 990 call
Sell 1 995 call
Sell 1 1000 call
Buy 1 1005 call
Technorati Tags: butterfly options, Butterfly Spread, butterfly strike, butterfly trade, Credit Spread, Iron Condor
photo credit: Arbron
If you took the shorts away from a butterfly spread you’d be left with a strangle.
I think a lot of butterfly spread traders would love to be able to trade their butterflies without the wings - or the strangle. Having to buy the wings cut into the total profit potential. It also weighs down the trade, causing it to take longer to reach the profit target.
But many brokers won’t allow it - for margin reasons as without wings there is technically unlimited loss in the trade. Which is also the reason why I guess we need those wings - to protect again the possible - the unforeseen - no matter how remote it may be.
Having the wings limits the total loss that is possible in the trade. They can also assist in the adjusting and management of a trade. After trading these for awhile and becoming comfortable and accustomed to adjusting - a butterfly spread trader can use the wings as quite a versatile ‘tool’ in tweaking and tuning in a trade - not only to hedge against a big move that would cause losses - but also in prying and pushing out profits from the position.
Technorati Tags: butterfly option, Butterfly Spread, butterfly trade, Credit Spread, Iron Condor, strangle spread
photo credit: Nick.Fisher
While changes in volatility will have an effect on butterfly positions - I’ve found that they are always less severe than they are say in a strategy like the calendar or double calendar spread.
With butterflies (as well as iron condors) a decrease in volatility will help your position - while an increase in volatility hurts it. However - while an increase in volatility can have a negative impact on your current profit and loss in a butterfly position - it doesn’t have an effect on your FINAL profit potential - your ‘Expiration Line’ on your option risk graph - so while you’re in a trade if the going gets rough and vols spike up - you can always feel confident that the profit potential that’s showing in your ‘profit tent’ is ‘real’ and if you can just successfully manage your way through the move that is occurring it’s yours for the eventually taking.
On the other hand - with a strategy like the calendar spread - or double calendar - changes in volatility can have a drastic - and even damaging effect. The ‘total profit potential tent’ you see on the risk graph at the inception of a calendar trade isn’t at all what you can always count on getting - as changes in volatility can raise and lower that tent dramatically - possibly putting your position suddenly way under water - leaving you with very little you can do to fix it.
Technorati Tags: butterfly option, Butterfly Spread, butterfly trade, butterfly volatility, calendar spread, Credit Spread, double calendar, Iron Condor
photo credit: wka
Having traded a wide variety of different option strategies - if not all of them (at least the ones that I’m aware of) - I’ve found butterfly spread trading to be the most consistent, the most enjoyable, the most manageable, and the most profitable of them all.
The thing with butterflies is that when they are sold at the money - you are bringing in a large amount of premium which becomes your ‘premium bank’ for which will give you your final profit - AND - be there for you to draw from to fund your adjustments through out the duration of the trade.
A trade like the Iron Condor - at least the ‘wider’ condors - will have so little premium built into the position that a trader is really limited in the number of adjustments that can be made without depleting the condors ‘premium bank’.
On the other hand - the butterfly - because you are selling the at the money options that hold the MOST amount of premium possible - you’re ‘premium bank’ for funding adjustments is almost always more than adequate - with plenty left over to become your profit from the trade.
Technorati Tags: butterfly option, Butterfly Spread, butterfly spread trading, butterfly trade, Credit Spread, Iron Condor
photo credit: Alexandre Hamada Possi
There are a number of different ways a trader can construct a Butterfly Spread.
The traditional Butterfly Spread is made up of either all calls or all puts. The short strikes are sold At The Money - while the long calls - or ‘wings’ - are bought an equal distance away from the short strikes on either side.
For example, a Butterfly Spread with puts might look something like this:
Purchase 1 60 put
Sell 2 65 puts
Purchase 1 70 put
An example of a call Butterfly Spread might look something like this:
Purchase 1 60 call
Sell 2 65 calls
Purchase 1 70 call
An Iron Butterfly is a butterfly spread made up of both calls and puts. Think of an Iron Butterfly as an Iron Condor - only with the short strikes which are sold at the money touching each other (or being the same strike). For example:
Purchase 1 60 put
Sell 1 65 put
Sell 1 65 call
Purchase 1 70 call
Also see http://www.ironcondor.net
Technorati Tags: butterfly option, Butterfly Spread, butterfly spread with puts, butterfly trade, Credit Spread, Iron Condor
February 2010 Expiration
Our Butterfly held up well this month considering the big fast down move we had which started on the same day we put this on. Would have liked to milk more out of this trade, but with the market starting to act a little batty decided to just take the money and run.
Technorati Tags: Butterfly Spread, Iron Condor
