The butterfly strategy is one of the most robust and versatile option selling techniques available.

In a lazy, quiet market condition there is very little - if anything - to do to manage these positions - other than watch your 0 day risk graph line rise up as your account grows - then close it out to collect your ‘trading paycheck’ at the end of the expiration cycle.

However, this is the case with basically all your standard theta positive monthly income type option strategies - like the iron condor, the calendar and double calendar - the double diagonal, etc.

What sets the butterfly strategy apart from the others is how this spread performs during extreme market conditions.

Ever since the crash in late 2008 delta neutral theta positive monthly income option trading has been a challenging endeavor. Yes, all the basic trades can and have worked - however during many of the months there is more work, adjustments, annoyance, and more stress involved then in past more peaceful times.

Out of all of the strategies - and I’ve traded them all through this period - the butterfly spread trade is the one that is the most robust - most consistent - most reliable - and the one that has given me the least amount of trouble and the most amount of profits.

And even though I do love condors - and I do love double calendars - and double diagonals… well - let’s talk about those later…

Anyway - if a low down dirty thug walked into my trading room one day and forced me at gunpoint to pick just ONE strategy I was allowed to trade for the rest of my life - it would have to be the butterfly spread.

I love you butterfly spread.

Where’s a tissue…

photo credit: mononukleoza

Butterfly Strategy is a post from: Butterfly Spread Trading Course

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Non directional trading enthusiasts will many times use the butterfly option strategy as a way take advantage of a stock or index or ETF that is caught in a chart range - or an underlying whose options provide good premiums but doesn’t gyrate wildly around.

Because the short strikes of these butterfly spread positions are usually sold ATM (at the money - or at the position on the chart where the stock or underlying asset is currently trading at) a large amount of premium - in fact largest amount that is possible - is collected at the start of the trade.

Again, option spread traders who use this option trading strategy will want to choose the underlying asset wisely - one which is either stuck in a price range or an underlying that doesn’t normally surprise, gap, or fly around on the chart. Many butterfly option traders prefer indexes or ETFs for these types of trade for this very reason.

As long as the the correct stock or index is chosen and the butterfly trade is placed, managed, and removed correctly - an individual can extract great monthly returns over time using this spread trading strategy.

photo credit: SearchNetMedia

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Butterfly Spread Trades can be composed of all call options, all put options, or both call and put options.

Regardless of how they are constructed - for the most part they appear the same in a trading platform risk graph pay off diagram window - and also for the most part they perform the same while the trade is on.

There are instances where exiting the butterfly spread trade can become somewhat of an issue when using an ‘all call option’ butterfly - or an ‘all put option’ butterfly.

This usually has to do with situations where the debit spread side of the trade becomes so far ‘in the money’ that it can be difficult to get a nice fill on those in the money option / spread when trying to exit the trade.

One way that this situation can be dealt with is to create a ‘box’ on the trade - which is buying and selling the exact opposite options that are so deep in the money. The exact opposite side of the trade will be out of the money and should be much easier to fill - and when done can ‘lock in’ the profit on that part of the trade.

photo credit: jontintinjordan

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“Just when you think you are smart, the market will show you just how really dumb you are.”  - Louis Navellier

“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.” - William Bernstein

Credit Spread

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March 2010 Expiration

Our Butterfly Spread Trade this month did beautifully. Opened this trade on 2-17-10. Closed it on 2-25-10 for a profit of just over 10% in 8 days.

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A butterfly spread is an options spread trade that takes advantage of the fact that options are decaying assets.

Butterfly spread traders SELL the options that have the MOST time premium - or the options that the MOST ‘fake’ or ‘unreal’ value.

As long as the underlying they are trading stays within a range - which the probabilities say they should - the trader should be able to ‘capture’ a large percentage of the TIME value as it disappears into ‘thin air’ - as time goes by.

The closer the trade gets to expiration day - the options will decay at a faster and faster rate.

And the butterfly trader only needs a small fraction of the premium he or she originally brought in by selling the at the money options to realize a very good return on investment.

And what happens if things don’t go so well - and the underlying doesn’t stay within the ideal range?

The trader is then able to utilize the huge amount of premium he or she brought into the trade by selling the At The Money options to ‘fund’ a number of different available adjustment techniques to keep the trade profitable.

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Traditionally traders might consider the Butterfly Spread to be a ‘neutral’ strategy - one that is used when the trader believes that the underlying being used will not move much and will remain in a relatively narrow range.

And while of course butterfly spreads do work - and work wonderfully - in such situations, butterflies can also be used if the trader believes the underlying will be making a directional move.

The thing with butterfly spreads is that you want to place the short strikes of the trade either at or as near as possible to where the underlying will be trading at expiration day. That is how and where the money is made in these trades.

So, if a trader had a directional bias on a particular underlying - and thought that it would rise up to a certain price within the time period to expiration - that trader could place a butterfly as a bullish spread.

To do so the trader would place an OTM (out of the money) butterfly trade with the short strikes sold at or near the strike price where the trader believed the underlying would be at expiration.

If the trader wanted to give himself more ‘room to be wrong’ he could place a wider butterfly - with the wings being further away from the sold short strikes - allowing his ‘profit tent’ to encompass a wider area of profitability around the sold short strikes.

If the trader had a crystal ball and was certain the underlying would wind up at a specific strike price at expiration day - he would want to sell a narrow butterfly trade - with the wings being as close to the sold strikes as possible - which would give him an enormous profit with very little risk in the trade - as long as of course, his crystal ball was right.

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When trying to understand a more complex options strategy, many times I find it easier to ‘reverse engineer’ the position, break it apart into pieces -understand what exactly those pieces are that make up the trade, then put them all back together again.

For example, an alternate way to look at the Iron Butterfly Spread is break the position apart and realize that this trade is actually just the Sale of a Straddle.

For example, the original iron butterfly position might look something like this:

Buy 1 35 Put
Sell 1 40 Put
Sell 1 40 Call
Buy 1 45 Call

However, when we break it apart, we could say that this trade is simply a sale of a straddle…

Sell 1 40 Straddle

and the purchase of a strangle…

Buy 1 35/45 strangle.

The sale of the 40 straddle is what the trader is utilizing to bring in the income.

The purchase of the 35/45 strangle is used as protective wings.

Butterfly Straddle is a post from: Butterfly Spread Trading Course

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There a several different types of butterfly spreads traders can put on.

Traditionally there is the call butterfly and the put butterfly. The call butterfly is constructed from ONLY call options - while the put butterfly is constructed from ONLY put options.

An example of a call butterfly would be:

Buy 1 25 Call
Sell 2 30 Calls
Buy 1 35 Call

And an example of a put butterfly might be:

Buy 1 60 Put
Sell 2 65 Puts
Buy 1 70 Put

Then there is the Iron Butterfly, with is made up from both calls and puts. One way to think of this butterfly spread is as an Iron Condor with the short strikes of either side being sold at the same strike price - or ‘glued’ together.

An example of an Iron Butterfly could look as follows:

Buy 1 45 Put
Sell 1 50 Put
Sell 1 50 Call
Buy 1 55 Call

Then there is the ‘Skewed Butterfly’ or the Broken Wing Butterfly.  In the above examples, the butterfly spreads shown had wings that were bought an equal distance away from the short strikes on either side. In the case of the Skewed or Broken Wing Butterfly this distance is not equal.

An example of a Skewed or Broken Wing Butterfly could looks as follows:

Buy 1 50 Call
Sell 3 55 Calls
Buy 1 65 Call

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The Iron Butterfly Spread is actually an Iron Condor. Even when in my option trading software platform - when selecting from their ‘trading strategies’ to place - when wanting to select an Iron Butterfly - it’s not one of their options. You must select ‘Iron Condor’ instead.

However, the payoff diagram of an Iron Butterfly looks just like the payoff diagram of a regular butterfly - and for the most part they act the same during the duration of the trade.

While a regular butterfly spread is made up of only calls or only puts - the iron butterfly spread is made up of both calls and puts - just like an iron condor spread. However unlike a traditional iron condor spread where the short strikes of the trade are placed some distance apart from each other - with the Iron Butterfly Spread - the shorts are sold at the SAME strike.

An example of an Iron Butterfly might look as follows:

Buy 1 50 Put
Sell 1 55 Put
Sell 1 55 Call
Buy 1 60 Call

Another way to think of the iron butterfly spread is to break the two halves of the spread apart. When you do, you can find that the iron butterfly is simply two vertical spreads - or credit spreads. A 55/50 Put Credit Spread and a 55 / 60 Call Credit Spread - with the short strikes of the two spread ‘glued’ together at the middle.

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I’ve spent a ton of money of various option trading courses over the years. Some good - some bad - but what I’ve found surprising is how almost ALL of them deliver only text book type information on ‘what is an option’ or ‘what is a butterfly spread’ or ‘what do the Option Greeks mean’, or ‘how do you navigate this trading software’ ect.

I have walked away from MOST of them with very little to NO practical knowledge whatsoever on HOW to actually trade options - HOW to successfully make money consistently trading options.

I’ve often wondered why that is.

And some of these courses weren’t just put out by mom and pop shops either. Some of these courses were taught by well known option market makers and high level traders who really DO know how to pull money consistently from the markets. So why don’t they - or ‘can’t’ they pass that information on to their students?

And again, these weren’t cheap courses either. Thousands of dollars were spent.

In any case - occasionally here and there I have found gems - programs that delivered knowledge that I could turn around right away, apply to my trading, and immediately see results.

Shortly I’ll put together a list here of the few that I have found, that, in my opinion are worth their weight in gold. So stay tuned…

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A great way for spread traders to get ‘hands on’ experience trading butterfly spreads, credit spreads, and iron condors - without being exposed to the risk - is to ‘paper trade’ them first.

Any option trading strategy - or any trading strategy for that matter - can act quite differently than one might expect when first just reading or learning about it in a book, video, or training course.

Think of it like a flight simulator. You want to learn how to fly a plane - so you read a book, take a class - but just reading or learning about it from a class certainly doesn’t mean you’re ready to climb into a plane and take off. It would be recommended (or at least should be recommended) that after your ‘book’ study - you climb into a flight simulator so you can get an idea of what it’s really like to fly - without risking your own life - or anyone else.

We should approach our trading the same way. Climb into a ‘trading simulator’ and put these trades on - watch them - manage them - and see how they act and perform. This information is priceless in our trading training - and we are able to really soak it in and learn without having the stress of worrying about losing real money.

Many option trading software platforms have ‘paper trading’ capabilities - and many of these are free option trading software. Recommended is to check out ThinkorSwim.com which provides a great paper trading software platform that looks and acts just like their live trading platform.

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On some software - like the ThinkorSwim.com option trading software platform - there may even be a colored vertical line that ‘highlights’ this area on the graph.

This area is important - because it is the point at which if / when the underlying moves through on either side - the position is really no longer ‘under the tent’ - or no longer within  the price range it needs to be in at expiration to be profitable.

These breakeven levels are significant when trading these option positions - and many traders use these ‘levels’ as a ’signal’ to take some sort of management action - like adjust. They use the spread’s ‘breakeven’ marks as their ‘cue’ that the position in now in danger - and something must be done to widen or move the tent to keep the underlyings current price contained in an effort to keep the option position profitable.

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A Reverse Butterfly Spread is a butterfly trade that can actually stop time in it’s tracks - then turn it on it’s heels and push it back - causing not only the stock market - but the entire world - to actually start ticking backwards.

This can be useful in a number of different ways. Say there was a sudden big move in the market forcing you to make an adjustment on a trade - only to have the market just as suddenly turn back around and take off in the opposite direction.

Well, playing the reverse butterfly spread - you could simply ride it back in time to when you made that unnecessary adjustment - and just not make it.

Pretty impressive right? Hey, I know. You don’t have to tell me - you’re preaching to the choir. For several years now I’ve been shouting from the roof tops how amazing and versatile these butterfly spread trades are…

Oh, all right.

I’ll get into what a Reverse Butterfly Spread Trade ‘really’ is next time.

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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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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

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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.

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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.

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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.

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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

Butterfly Spread With Puts is a post from: Butterfly Spread Trading Course

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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.

FEB ‘10 RUT BUTTERFLY SPREAD - IRON CONDOR CLOSED is a post from: Butterfly Spread Trading Course

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October 09 Expiration

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September 09 Expiration

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8-10-09 (above)

Risk graph above shows position after numerous adjustments and heading into final week before expiration…

8-12-09 (above)

Closed this RUT Butterfly with small profit - letting the contracts in graph directly above expire worthless. The move in the market this month gave us a run for our money and happy to get out with the little we wound up with.

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8-3-09 (above)

8-17-09 (above)

8-17-09 (above)

8-19-09 (above)

Due to the quick big move in the market this month, this trade also required a lot of adjusting. We rode this trade longer than we normally do - until the Wed. before expiration. Risk graphs from trade / adjustments above…

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Risk Graph directly above is of trade right before closing.

This Risk Graph (directly above) is of trade shortly after initiating the position.

The current market climate has been perfect for trading these butterfly spread trades - and even though we have had to adjust, it has been minimal and actually even enjoyable. Much different way of trading butterflies compared to late last year.

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6-24-09

This months butterfly spread trade was short and sweet - just 8 days in the trade. Fairly straightforward and there was nothing too new or out of the ordinary while managing this. The market has been cooperating nicely for these butterfly trades as well as our iron condors.

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6-15-09

6-15-09

This months Spy Butterfly did nicely. On closure of main position left some extra OTM long calls on since they were worth less than what it would have cost in commissions to close them - AND - if the market blasts off for some reason before expiration day they could become a nice little lottery ticket.

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Squeaked out a tiny profit on this June IBM Butterfly. It’s been so long since trading IBM Butterflies (last fall) it somehow slipped the mind to take into account the difficulty in adjusting with only 5 point wide strikes with little time left until expiration (compared to the indexes where there is a strike at every point). On this trade utilized next month out (July) put credit spreads to keep theta in check while adjusting with the idea being could always just keep them if need be as part of a July Butterfly. However, in end closed out entire trade with small gain - leaving on far out of the money long calls as ‘lottery tickets’ because they were worth less than what it would have cost in commissions to close them out.

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This Butterfly Spread Trade was up over 10% until the big move on 6/1 forcing us to adjust. In hindsight we probably should have taken it off the last friday in May while we were up and the going was good - but then again - who knew. In any case, this return in 23 days certainly isn’t anything to complain about. Above is risk graph of the trade right before we took it off.

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5-14-09

This month we used a strategy called ‘Theta Scalping‘ to adjust our SPY Butterfly Spread trade. This adjustment strategy involves using the underlying STOCK in conjunction with the trade to adjust the position instead of using just the options.

This month, when SPY first shot up, we did our first round of adjustments using only SPY options like we usually do. However after the first round was complete, we then switched and rode out the rest of the trade adjusting with SPY stock.

What’s interesting about adjusting using the stock is that the trades theta DOESN’T decrease like it does when using options to adjust. When using options, the theta of the trade can get cut down causing the trade to make less through time decay. Using the stock to adjust, we were always able to get back towards delta neutral without any real decrease in theta.

This way of adjusting can be used with iron condors and calendar spreads as well.

Below is a screen grab of this trade about a week after it was first initiated and a day or two before SPY shot up causing us to make or first round of adjustments (around 5-1-09)…

5-1-09

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DIA OBDB BUTTERFLY SPREAD - Risk Graph above on close of trade - 5/14/09

DIA OBDB BUTTERFLY SPREAD - Risk Graph above on 5/2/09…

DIA OBDB BUTTERFLY SPREAD - Risk Graph above on 4/25/09

We started this Butterfly Spread Trade off as a Double Butterfly. The move up from around 78 to 85 forced an adjustment. We eventually exited in expiration week with a profit.

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The butterfly spread is a positive theta trade - meaning that this trade makes money from the decay of the options in the positions over the passage of time.

Butterfly options traders will utilize the butterfly strategy when they believe the underlying will stay within a range - or they have an opinion where the underlying will be on the price chart on expiration day.The butterfly trade makes its money when the underlying stays or winds up at the short strikes of the position on expiration day. Ideally a butterfly spread trader wants the underlying to stay within a range determined by where the bull spread and bear spread where bought or sold.

An example of an option butterfly spread is as follows: - Example underlying: SPY. Buy 1 80 call. Sell 2 85 calls. Buy 1 90 call. It is also possible to create a butterfly position of both calls and puts (rather than a butterfly position made up of only calls or only puts.) For example - a butterfly on the ETF SPY could be made up of the following strikes:Buy 1 80 put. Sell 1 85 put. Sell 1 85 call. Buy 1 90 call.

Another reason option traders particularly like butterfly spreads is because of the amount of premium that is brought into the trade. Because the sold strikes of these trades are usually sold at the money - butterfly traders are bringing in the max amount of premium possible - and this in turn can provide a higher return on investment than other similar option strategies. It also allows the trader more flexibility in making adjustments.

The butterfly strategy is a favorite trade of option traders and is used by many professional traders as well as retail traders who are ‘in the know’ to generate consistent monthly income. Many times option traders prefer these trades over other popular income trades because they could be viewed as a superior strategy. For example, when compared to the iron condor trade - butterfly spreads can be easier to manage and adjust. When compared to the calendar spread - a trader knows for certain what they can wind up with profit wise regardless of what happens to volatility levels.

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