Butterfly Spread Payoff Diagram
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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.
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