Posted on Thursday, March 27, 2014 at 1:30 PM
Many option traders use butterfly spreads for a neutral outlook on the underlying. The position is structured to profit from time decay but with the added benefit of a “margin of error” around the position depending on what strike prices are chosen. Butterflies can be great market-neutral trades. However, what some traders don’t realize is that butterflies can also be great for trading directionally.
The long butterfly spread involves selling two options at one strike and the purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are referred to as the wings and the short options are the body; thus called a butterfly.
The trader's objective for trading the long butterfly is for the stock to be trading at the body (short strikes) at expiration. The goal of the trade is to benefit from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value; and the lower strike call on a long call butterfly or higher strike put for a long put butterfly have intrinsic value. Maximum loss (cost of the spread) is achieved if the stock is trading at or below the lower (long) option strike or at or above the upper (long) option strike.
What may not be obvious to novice traders is that butterfly spreads can be used directionally by moving the body (short options) of the butterfly out-of-the-money (OTM) and maybe using slightly wider strike prices for the wings (long options). This lets the trader make a directional forecast on the stock with a fairly large profit zone depending on the width of the wings.
To implement a directional butterfly, a trader needs to include both price and time in his outlook for the stock. This can be the most difficult part for either a neutral or directional butterfly; picking the time the stock will be trading in the profit zone. Sometimes the stock will reach the area too soon and sometimes not until after expiration. If the trader picks narrow wings (tighter strikes), he can lower the cost of the spread. If the trader desires a bigger profit zone (larger strikes), he can expand the wings of the spread and the breakevens but that also increases the cost of the trade. It’s a trade-off.
One of the biggest advantages of a directional butterfly spread is that it can be a relatively low risk and high reward strategy depending on how the spread is designed. Maybe one of the biggest disadvantages of a directional butterfly spread is that its maximum profit potential is reached close to expiration. But being patient can be very good for a trader…most of the time!
Senior Options Instructor