How To Trade Butterfly Spreads

A butterfly spread is one of my favorite spreads. Butterfly spreads limit your profit, and more importantly limit your risk, they can be easily constructed by combining 2 other spreads the bull and bear spread and are easily evolved into iron condors. It’s a neutral strategy – to be avoided with strongly trending markets.

If you’re new to trading options, the butterfly is one of the first spread strategies you’ll learn.

The hard thing to learn aren’t the strategies themselves, but the evolution of the strategies. For example, if last week I was expecting the market to break resistance and move higher, I might put on a bull spread, yet the market stayed flat and Vol is going nowhere. What possibilities do I have? Should I evolve that bull spread, bail, or leave it as it is? If I see the market staying flat and I want to stay in the trade, I add a bear spread. Voila, I’ve constructed a butterfly. This is exactly what makes options trading so interesting and difficult. The evolution of your positions.

I’ll keep things simple and we’ll look at the butterfly as a strategy in itself but keep in mind, it’s an easy strategy to ‘ease into’.

A long butterfly is built by selling 2 inside calls usually ‘At The Money’, and by buying 1 outside call (on each wing).

+1 ITM
-2 ATM
+1 OTM

Profit and loss looks like this, you’ve seen the chart…

long-butterfly

 

Lets take a real example from today’s close. I’ll use the SPY as an example and point out some of the advantages and disadvantages of a butterfly with the SPY at the moment.

The chart, looking at a monthly perspective.

spy2mo130115

Using the February Strike, At The Money, we need to sell 2 (I trade in 10 blocks to keep the ratios clear) at 202.

First, you’ll be selling 2 At The Money 202 strikes, they’re $4.60. Next, start considering which wings interest you. How do you do that? What are you range expectations? What type of Volatility will I see? Remember a butterfly is a neutral strategy! You want this trade to close at 202 – or as close as possible (your short leg). The option chain, OI and some IV is below.

Note: You do have a little help with the volatility and pricing,  it’s a good idea to keep an eye on value, as well. I do this rapidly using the VIX levels, they help me create triggers for entering and/or exiting spread trades on the SPY. The VIX also has levels of support and resistance, and you can use these levels to time your entry or exit. Selling is better done when the VIX is high, and buying when the VIX is low. Obviously… But if you plan on constructing your butterfly with a bull-spread leg and a bear-spread leg, this becomes more important.

spyoptionchain130115Back to the SPY. What’s the chance the SPY will close at 202? We can identify atleast 2 ranges over the 2 month period on the chart above. An inner 200 – 206 channel, and outer 198 – 209  band. We’ll use these ranges to identify the wings of our butterfly, but to make a clean butterfly we need to buy 1 ITM and 1 OTM – at equal distance from our short. Lets look first at the inner channel with a 199/205. (I like 199 because 200 has some psychological value as resistance.)

Look at the P&L for a 199/202/205 butterfly.

spy199-202-205

You have a max profit of ~ $2500 and a max loss of ~ $460. That’s ~ 5:1. Not bad, but 199/202/205 is a very tight range. We’ve moved in and out of that range, just this week… Attention, If you’re new to this, there’s a panic ‘risk’ with this particular trade. If you’re expecting such a tight range you’d be expecting a big drop in Vol. It’s nearly sure we’ll break these ranges. You have to be prepared for that. How? It’s called the Iron Condor, but that’s for another time!

Lets reduce our panic risk and move the wings out, what happens? I’d propose a 196/202/208 spread. Why? Because these levels reflect our longer term outer range. Look at the first chart and the ranges I’ve drawn, you’ll see what I mean. The SPY has been volatile, but bound between 198 and 209 for over 2 months. Might it continue? Do I feel more comfortable with this range?

spy196-202-208

In this case, you have a max profit of ~$4500 and a max loss of ~$1500. That’s 3:1. Not as good as the 5:1, but is this not a better trade? It gives me a little more breathing room. The SPY has been very volatile lately and that makes for a hard neutral trade, but volatility is price discovery.

There are some extreme opinions about whether the market should be going to the QE moon or tanking with a deflationary Europe, and low oil prices. If the truth lies somewhere between these extremes a neutral trade is perfect, and the butterfly is a good choice.