Butterfly

A butterfly strategy combines two call spreads or two put spreads; it involves four call legs, or four put legs, all with the same expiration date, generally with consistent distances between strike prices. The strategy gets its name from its 3-part structure, involving the two outer strikes (or "wings") and the middle strike (representing the "body").

Long Butterfly (Calls)

A long butterfly is created by purchasing a lower strike Call, selling double the quantity of a consecutively higher strike Call, and purchasing a consecutively higher strike Call. In order to be considered a standard butterfly, the 3 strike prices involved should be equidistant.

Example:

• Buy to Open 1 XYZ 01/17/2015 70.00 Call
• Sell to Open 2 XYZ 01/17/2015 75.00 Call
• Buy to Open 1 XYZ 01/17/2015 80.00 Call

If the strike prices are not equidistant from each other, the butterfly is considered to be a "broken wing" butterfly.

The cost to purchase the outer strikes typically exceeds the premium received from selling the (double quantity) middle strike; therefore, a long butterfly is typically established as a net debit position.

For use when investor anticipates:

• Neutral outlook
• Little to no movement in security price (e.g. sideways channels)
• Low volatility

Financial Characteristics:

• Maximum Loss: Initial Net Debit paid
• Maximum Gain: Difference between middle strike price and outer strike price, less net debit
• Loses value with time

Objective:

• Gain from correctly predicting price at expiration

EXAMPLE - Long Butterfly

Assume it is June 19th, 2014 and Tom, a trader, has identified XYZ as a stock that he believes will trade relatively flat over the next month. Therefore, he decides that a Long Butterfly is an appropriate strategy given his outlook. XYZ is currently trading at $64.90 and Tom decides that the 65.00 Call is an appropriate middle strike since it is just above the current price. In addition, he feels that the 62.50 and 67.50 strike prices create an appropriate “wingspan” for this position. Lastly, Tom selects the July expiration, since it is 30 days away which is in-line with his timing forecast.

 

Source: StreetSmart Edge

Trade Setup

Here is the breakdown for Tom's setup and trade:

• Current XYZ Price = $64.90
• Current Ask Price, XYZ 07/19/2014 62.50 Call = $3.85
• Current Bid Price, XYZ 07/19/2014 65.00 Call = $2.41
• Current Ask Price, XYZ 07/19/2014 67.50 Call = $1.42
• Tom's Trade:
  • Buy to Open 1 XYZ 07/19/2014 Call @ $3.85
  • Sell to Open 2 XYZ 07/19/2014 Calls @ $4.82 ($2.41 x2 = $4.82)
  • Buy to Open 1 XYZ 07/19/2014 Call @ $1.42
  • Net Debit = $3.85 - $4.82 + $1.42 = $0.45

The Profit/Loss profile for this trade is as follows:

Note: Chart depicts strategy at expiration

• Maximum Gain = $65.00 - $62.50 - $0.45 = $2.05
• Maximum Loss = $0.45
• Lower Break-Even = Lower Strike Price + Net Debit = $62.50 + $0.45 = $62.95
• Upper Break-Even = Higher Strike Price - Net Debit = $67.50 - $0.45 = $67.05

Note: Commissions have been excluded to simplify the calculations. Short options can be assigned at any time and therefore option sellers assume the risk of assignment at any point up until and including expiration.

Short Butterfly (Calls)

A short butterfly is created by selling a lower strike Call, purchasing double the quantity of a consecutively higher strike Call, and selling a consecutively higher strike Call. In order to be considered a standard butterfly, the 3 strike prices involved should be equidistant.

Example:

• Sell to Open 1 XYZ 01/17/2015 90.00 Call
• Buy to Open 2 XYZ 01/17/2015 95.00 Call
• Sell to Open 1 XYZ 01/17/2015 100.00 Call

If the strike prices are not equidistant from each other, the butterfly is considered to be a "broken wing" butterfly.

The premium received from selling the outer strikes typically exceeds the cost to purchase the (double quantity) middle strike; therefore, a short butterfly is typically established as a net credit position.

For use when investor anticipates:

• Significant movement in security price (in either direction)
• Higher volatility

Financial Characteristics:

• Maximum Loss: Difference between middle strike price and outer strike price, less net credit
• Maximum Gain: Initial net credit received

Objective:

• Gain from significant change in price of the underlying security (either up or down) by expiration

EXAMPLE - Short Butterfly

Assume it is July 15th, 2014, and Lauren, a trader, has identified XYZ as a stock that she believes will make either a sharp move higher or lower over the next month. Therefore, she decides that a Short Butterfly is an appropriate strategy given her outlook and the limited risk that the strategy offers. XYZ is currently trading at $32.00 and Lauren decides that the 32.00 Call is an appropriate middle strike since it is right at the money. In addition, she feels that the 30.00 and 34.00 strike prices create an appropriate “wingspan” since she feels that the underlying price will either be below $30.00 or above $34.00 at expiration. Lastly, Lauren selects the August expiration since it is 32 days away, which is right in-line with her timing forecast.

 

Trade Setup

Here is the breakdown for Lauren's setup and trade:

• Current XYZ Price = $32.00
• Current Bid Price, XYZ 08/16/2014 30.00 Call = $2.17
• Current Ask Price, XYZ 08/16/2014 32.00 Call = $0.90
• Current Bid Price, XYZ 08/16/2014 34.00 Call = $0.23
• Lauren's Trade:
  • Sell to Open 1 XYZ 08/16/2014 Call @ $2.17
  • Buy to Open 2 XYZ 08/16/2014 Calls @ $1.80 ($0.90 x 2 = $1.80)
  • Sell to Open 1 XYZ 08/16/2014 Call @ $0.23
  • Net Credit = $2.17 - $1.80 + $0.23 = $0.60

The Profit/Loss profile for this trade is as follows:

Note: Chart depicts strategy at expiration

• Maximum Gain = $0.60
• Maximum Loss = ($32.00 - $30.00) - $0.60 = $1.40
• Lower Break-Even = Lower Strike Price + Net Credit = $30.00 + $0.60 = $30.60
• Upper Break-Even = Higher Strike Price - Net Credit = $34.00 - $0.60 = $33.40

Note: commissions have been excluded to simplify the calculations.

Commissions, taxes, and transaction costs are not included in any of these strategy discussions, but can affect final outcome and should be considered. Please contact a tax advisor to discuss the tax implications of these strategies. Many of the strategies described herein require the use of a margin account.

Qualified Spreads

With a Qualified Spread, the purchased option is required to expire on the same or later expiration date than the option sold. When there is more than one possible way to pair available options in your Account, Schwab has the discretion to determine the spread pairings. Schwab may pair options in a manner that does not produce the lowest possible margin requirements.

Note: For butterfly and condor spreads, each option leg must have the same expiration date to qualify as those types of spreads.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Multiple leg options strategies will involve multiple commissions. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options." Member SIPC