The Option Butterfly - A High Probability, Low-Risk Options Strategy

By Larry Gaines, PowerCycleTrading.com

March 24, 2016

Butterflies provide a low risk high reward trading opportunity. Markets direction can go through months, and even years of higher than usual uncertainty. Technical analysis may be painting one picture, while the economic or political environment is painting another. This can be both stressful and costly. The Butterfly strategy offers a solution to this dilemma that all traders face on a regular basis.

While there’s always some degree of uncertainty that traders and investors must accept, there can be long frustrating periods of higher than usual conflicting signals. This increases risk for traders and investors. Yet, waiting on the sidelines has opportunity costs. For traders who have come to rely on regular income from trading, loss of that income can cause serious lifestyle problems. These situations call for a strategy that will work no matter which direction the market heads.

That’s exactly what the highly versatile Butterfly strategy does. It gives you a trading advantage in any type of market environment. This makes it a powerful strategy that every serious trader will want to add to their arsenal of skills.

Many traders know of the advantages of the Butterfly, yet they may have avoided it because of its complexity. Initially, the setup can seem overly complicated. This is because most traders try to master the Butterfly without truly understanding a few basic option trading principles first.

In this chapter, I’m going to simplify the Butterfly for you. The reality is that once you grasp these basic concepts, you’ll see that the Butterfly is just marrying a couple of simple setups that you probably already know. Serious traders take the time to master the skills to increase their returns while lowering their risk. The Butterfly is one powerful way to do that. Since many traders avoid the Butterfly, by taking time to master it is going to give you a powerful edge up on traders who continue to avoid it.

Best Market Conditions for Butterflies

Unlike other option strategies such as iron condors, credit spreads, or debit spreads that only work with an identified objective based on probable market direction, Butterflies can be set up and traded for a variety of objectives based on where a trader thinks the security or market is headed, as outlined below. One of the best things about Butterflies is that they are ideal regardless of market direction!

1. You Just Don’t Have Any Idea Where the Market is Headed

Non-Directional – Here’s the real beauty of the Butterfly! In their simplest form, butterflies can be delta neutral or non-directional trades. This means they can be used successfully when you simply DO NOT KNOW the market direction. Trying to pick the direction of stocks or the overall market can be stressful and expensive. Delta neutral butterflies can be set up to take the guesswork out of trading.

2. You Feel Pretty Sure the Market Is Headed Up or Down

Directional – The Directional Butterfly Spread can also be used for bullish or bearish exposure to the market while also managing risk and retaining large potential returns.

There’s no such thing as a free lunch: Butterfly spreads cannot offer unlimited profit potential. But they usually cost less than buying options outright while providing a powerful positive risk reward trade set-up that simply cannot be found with other trading strategies.

3. You Don’t Want to Lose Your Shirt!

Hedging – The Directional Butterfly can be used as a fast to execute hedge on positions that are moving against you. This is exactly what the most sophisticated companies do. They hedge, and so can individual traders! Note: This lowers trading stress!

Constructing a butterfly around a strike that is under pressure from another core trade (such as a credit spread or debit spread) controls risk.

This allows you to keep the original position open, buying time. Often, additional time is all that’s needed for a trade to move back to profit territory. At that point you can then remove the butterfly hedge and stick with your original trade.

Butterflies provide cheap protection! Many longer-term investors and swing traders buy puts for portfolio insurance. Long term out-of-the-money put butterflies, however, can be a much cheaper method of portfolio protection than pure long puts.

Benefits of Butterflies:

Income - Butterflies can be used to generate income from stocks that appear to be going nowhere in the short term. This alleviates overall portfolio returns in flat markets.

Low Cost - Butterflies can best structured and traded at a very low cost.

Risk Reward - A 10-to-1 or higher Reward-to-Risk is common. This fantastic risk reward ratio makes them well worth the effort to learn the structure.

Low Maintenance – Butterflies are sometimes called “vacation trades

due to their low risk and need for only very infrequent monitoring.

  • Butterfly trades are generally very slow moving early on in the trade.
  • But get more exciting and volatile as they approach expiration and are within the profit tent (Zone).

The Most Important Option Factor

The most important option factor for profit generation using the Butterfly Strategy comes down to understanding the concept of TIME, and its effect on the price of an option…

Time Value ~ is used for trading strategies that take advantage of the accelerated Time Decay of an option into its Expiration. Butterfly Strategies are very tied to Time Value (Theta) & the impact it has on the price of an option.

What exactly is Time Value?

Time value (TV) (extrinsic) of an option is the premium a rational investor would pay over its current exercise value (intrinsic value), based on its potential to increase in value before expiring. This probability is always greater than zero, thus an option is always worth more than its current exercise value. The change in the value of an option, based on Time Decay, can be measured using the Greek, Theta…

Option Theta

Theta tells you how much an option’s price will diminish over time, which is the rate of time decay of a stock’s option. Time decay occurs because the extrinsic value, or the Time Value, of options diminishes as expiration draws nearer. By expiration, options have no extrinsic value and all Out of the Money (OTM) Option

expire worthless. The rate of this daily decay all the way up to its expiration is estimated by the Options Theta Value. Understanding Option Theta is extremely important for the application of option strategies that seeks to profit from time decay.

Options Theta – Characteristics

Option Theta values are either positive or negative.

All long stock option positions have negative Theta values, which indicates that they lose value as expiration draws nearer.

All short stock option positions have positive Theta values, which indicates that the position is gaining value as expiration draws nearer.

Theta value is highest for At the Money (ATM) Options, and progressively lower for In-The Money (ITM) and Out-of-The Money (OTM) options. ITM and OTM options have much lower extrinsic values, giving little left to the decay.

For example: An option contract with Option Theta of -0.10 will lose $10 per contract every day even on weekends and market holidays. The buyer/holder of an option contract over a 3-day long weekend with a price of $1.40 or $140 per option contract and an option theta of -.10 will find the price of that option at $110 instead of $140 after the 3-day weekend.

Theta Decay Strikes!

Option theta does not remain stagnant. It increases as expiration draws nearer and decreases as the options go more and more In-The-Money or Out-of-The Money. In fact, the effects of Option Theta decay are most pronounced during the final 30 days to expiration where theta soars.

Take a look at the following chart to see just how predictable and powerful this option paradigm is!

How Option Pricing Works:

How to value an option

Time Value (x) Implied Volatility (x) Intrinsic/Extrinsic Value

Note: Once you know these variables then you are ready to price an option & know what its option premium should be.

The Butterfly Foundation - Vertical Spreads:

Butterfly Foundation: Vertical Debit & Vertical Credit Spread

Vertical Debit Spread:

A “bull call” spread, entails buying one call and selling a higher-strike call that will be lower in price to offset some of the premium cost & theta decay

A “bear put” spread entails buying one put and selling a lower strike put, that will be lower in price to offset some of the premium cost & theta decay

Vertical Credit Spread:

A “bear call” spread, entails selling one call and buying a higher-strike call that will be higher in price to hedge the short call. Premium collection.

A “bull put” spread, entails selling one put and buying a lower strike put that will

be lower in price to hedge the short put. Premium collection.

Vertical Bull Call Debit Spread

Vertical Bear Call Credit Spread

Selecting the Right Butterfly Option Strategy:

One major goal of every trader should be to select trades based on what provides the most consistent positive return with low, defined risk. Not always the greatest return. And one of the best ways to achieve this is by knowing the Option Butterfly Strategies that are available, how they work, and then selecting the one that is best suited for the market environment you are trading.

  • Long Call or Put Butterfly
  • Short Call or Put Butterfly
  • Broken Wing Call or Put Butterfly
  • Unbalanced-Ratio Butterfly
  • Broken Wing Unbalanced-Ratio Butterfly
  • Directional Butterfly
  • Iron Butterfly
  • Hedging – Defenses Using Butterflies

My Favorite Butterfly Trades:

Long Call or Put Butterfly Spread

  • A combination of a bull call debit spread and a bear call credit spread
  • It is a limited profit, limited risk options strategy
  • There are 3 striking prices involved in a butterfly spread and it can be constructed using calls or puts
  • Called a butterfly spread because you are short the body & long the wings
  • Can be used as a neutral or directional option trading strategy
  • Trade results in a small net debit & max risk is the debit paid
  • Due to small net debit, this strategy offers a great risk-to-reward
  • Short Volatility & Theta Strategy
  • A target price pinning strategy

Max Profit

The maximum profit occurs should the underlying stock be at the middle strike or body at expiration.

In that case, the long call with the lower strike would be in-the-money and all the other options would expire worthless.

The profit would be the difference between the lower and middle strike (the wing and the body,) less the premium paid for initiating the position, if any.

Max Loss

The Maximum loss occurs should the underlying stock be outside the wings at expiration.

If the stock were below the lower strike all the options would expire worthless

If above the upper strike all the options would be exercised and offset each other for a zero profit.

In either case the premium paid to initiate the position would be lost.

Unbalanced Butterfly or Ratio Butterfly

  • This is another variation of the regular, equal strike, butterfly but adds an additional short vertical credit spread
  • It’s simply 2 in-the-money or out-of-the-money credit spread, protected by a slightly narrower, closer to the money debit spread
  • This is for the more aggressive trader
  • Like the Broken Wing Butterfly Spread it alters the risk to one direction & increases the potential reward
  • Increases the income potential, but also increases the risk

Everyone loves low risk, but low risk trades don’t come without the skills to structure and execute high level spreads that work...

Most traders shy away from complex option spreads, even the pros. Plus, these advanced trade (and often lower volume) setups are way too complex for enormous institutional accounts to trade for their clients, but this spells opportunity for you.

Why? Because you know that for less than the time it takes to play a few holes of golf, you can master these setups.

And you also know that as an individual trader, you can slip in and out of trades that the big guys (Wall Streeters, or “Suits”) just can’t do because they're too HUGE. I know; I used to be on the "other side".

THE SPECIAL OFFER

“Butterfly Trading Made Simple”

The Option Butterfly is a dynamic High Reward Low Risk option strategy that is ideal for a wide variety of trades with different goals in mind:

  • Income
  • High Reward Low Risk Directional
  • Non-Directional Trades
  • Hedging and More


Click Here to Learn More About Trading Options Butterfly Spreads

ABOUT THE AUTHOR

Larry Gaines

Author: Larry Gaines, Founder 
Company: Power Cycle Trading 
Website: PowerCycleTrading.com 
Services Offered: Trading Courses, Boot Camps, Custom Indicators 
Markets Covered: Stocks, Options, Futures, ETFs, Day Trading, Swing Trading

Using his in-depth knowledge and experience, Larry developed the Power Cycle Trading™ Model to allow for greater profits with a more disciplined, systematic degree of trading success.

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