Using a Butterfly to Lock in Profits


Posted on Wednesday, June 7, 2017 at 4:32 PM

Here is a topic I have talked recently and quite frequently with several of my one-on-one students; locking in profits with an adjustment. There are several ways to make adjustments or lock in profits on a profitable long call or long put position. One of my favorites has to be converting the option position to a long butterfly spread. It may sound funny, but probably the hardest part about an option trader converting his position to lock in profits with a butterfly spread is getting to a profitable position in the first place; the rest is relatively easy! Let’s take a look at a scenario and an outlook in which this butterfly spread can be considered.

Butterfly Spread on AAPL

Let’s assume an option trader has been watching Apple Inc. (AAPL) stock and noticed the stock pulled back slightly from the uptrend in which it has been trading in the middle of May. When Apple stock was trading around $150, he decides to buy the June 150 call options for 3. Lo and behold the stock moved higher over the last couple of weeks and is trading close to the $155 area. The $185 level is potential resistance for the stock because it has previously traded to that area twice before and the trader is concerned it might happen once again. The trader thinks there may be a chance that AAPL may trade sideways at that level. Converting a long call position to a butterfly spread is advantageous if a neutral outlook is forecast (as in this case). A long butterfly spread has its maximum profit attained if the stock is trading at the short strikes (body of the butterfly) at expiration.

The option trader is already long the June 150 call which constitutes one wing of the butterfly so he needs to sell two June 155 calls which is the body of the butterfly and where the option trader thinks the stock may trade until expiration. The $155 level represents where the maximum profit can be earned at expiration. A June 160 call (other wing) would need to be purchased to complete the long call butterfly spread.

The original cost of the June 150 call was 3. The two short June 155 calls sell for 2 (rounded for ease) apiece and the long June 160 call costs 0.50. The converted 150/155/160 long call butterfly spread produces a credit of 0.50 (-3 + 4 (2 X 2) – 0.50). Now here’s a look at the possible scenarios that could happen and some possibilities that can be considered.

Take Profit

With AAPL trading around $155, the June 150 call option has increased in value to 6. That means the trader can sell the call and make a profit of $3 (6 - 3). Certainly, this is a viable option and should be considered on some of the contracts before adjusting the position.

Maximum Loss

Maximum loss for a long butterfly spread is realized if the stock is trading at or below the lowest strike (lower wing) or at or above the highest strike (higher wing). In this case the maximum loss is not a loss at all but a credit of $0.50. In essence, the original $3 potential risk from buying the June 150 call is now erased and has turned into a guaranteed profit even if AAPL completely collapses. If the stock continues to move higher and past the 160 strike at expiration, the maximum loss is still achieved; albeit a $0.50 profit. But more could have been made by simply keeping the original position intact. That is why it may be prudent if there is more than one contract (long call) to maybe not convert all the positions to a butterfly spread, particularity if the trader thinks that the stock can still climb higher. Keeping the long call would have more profitable if this scenario played out.

Maximum Profit

Maximum profit is achieved if the trader is right and stock closes right at $155 at expiration. The current profit on the trade is $3 as discussed above. If Apple stock continues to trade sideways or ends up at $155 at expiration, that $3 profit has now grown to an $5.50 profit. The maximum profit for a butterfly spread is derived from taking the difference between the bought and sold strikes which in this case is $5, and adding premium received from converting the position to a butterfly spread ($0.50). Not too bad of a result if the stock trades sideways or ends up at $155 at expiration. It seems pretty clear that the long butterfly spread is very beneficial when a sideways outlook is forecast after the long option has profited.

As long as the strike prices align with the trader’s outlook, converting a long call or a long put to a butterfly spread can be very effective after gains are realized. If there are multiple contracts, it allows an option trader to take profits now and also potentially earn more if the stock essentially goes nowhere and ends up close to the short strikes at expiration.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

« Previous PostSprints Initiate Trends Next Post »Define Value and Define Risk

Please add your comments

Options Trading Blog