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In previous articles I've written on Seeking Alpha, I have mentioned the 'strangle' options trade to play high volatility stocks around earnings releases. The complete opposite of the 'strangle' trade is the 'butterfly spread'. If you are looking for an options strategy that can generate a nice weekly and monthly income, then the butterfly option spread may be what you need to consider. The 'butterfly spread' is a neutral option strategy that profits when there is little change in the underlying stock price. It is a limited profit, limited risk options trade.

With this strategy, you really want to stay away from stocks with high high volatility (implied or historical). This is also not a strategy you want to use before a company reports their quarterly earnings, due to the increased implied volatility and large price moves that can take place both before and after releasing their earnings.

I actually prefer to use this strategy on options that have little time-value left. With the butterfly spread, time is your enemy. Often, it is placed without much upfront cost to the trader, which does makes it very appealing.

I have found that this strategy works great on tight, range-bound stocks. Here is a list of the following stocks I have used the butterfly spread strategy on with success:

  • AT&T (NYSE:T) - 52 week-range is $27.20 - $31.94
  • Walmart (NYSE:WMT) - 52-week range is $48.31 - $59.40
  • Microsoft (NASDAQ:MSFT) - 52-week range is $23.65 - $29.46
  • Johnson & Johnson (NYSE:JNJ) - 52-week range is $57.50 - $68.05
  • Pfizer (NYSE:PFE) - 52-week range is $16.25 - $21.45
  • Intel (NASDAQ:INTC) - 52-week range is $19.16 - $25.20
  • Bristol-Meyers Squibb Company (NYSE:BMY) - 52-week range is $24.97 - $33.27

Here are the basics of how to employ a butterfly spread. To simplify the explanation for this article, I will use the minimal amount of contracts needed to accurately put the trade on. There are three separate "legs" and three different strike prices on a butterfly spread.

  • Leg 1: Buy one (1) in-the-money call
  • Leg 2: Sell two (2) at-the-money calls
  • Leg 3: Buy one (1) out-of-the-money call

As you can see, the first leg is placed as a net debit. The second leg is placed as a net credit, and the third leg is placed as a net debit.

The formula for realizing the maximum profit is achieved when:

  • Max Profit = Strike Price of Short Call - Strike Price of Lower Strike Long Call - Net Premium Paid - Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Short Calls

Here is the formula to understand the maximum risk (which is limited to the debit paid to enter the trade).

  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying <= Strike Price of Lower Strike Long Call OR Price of Underlying >= Strike Price of Higher Strike Long Call

As a hypothetical trade scenario, let's take a look at placing two (2) different types of butterfly spreads on AT&T (T). For these hypothetical trades, we will have one trade with the contracts and strike prices placed with an expiration to the forward month, and the second trade will use weekly expirations.

1.) Entered Trade- December Expiration (T)

-Buy ten (10) December $27.00 strike calls

-Sell twenty (20) December $29.00 strike calls

-Buy ten (10) December $30.00 strike calls

Price Cost
Buy 10 T Dec11 27 Call $2.37 $2,370.00
Sell -20 T Dec11 29 Call $0.78 ($1,560.00)
Buy 10 T Dec11 30 Call $0.30 $300.00

Requirements

Cost/Proceeds $1,110.00
Option Requirement $1,000.00
Total Requirements $2,110.00
Estimated Commission $50.00

Here is a look at at the profit/loss chart for (T) on this butterfly spread trade:

Current Price: $29.19

Price Profit / Loss
20.25 ($1,110.00)
23.56 ($1,110.00)
27.00 ($1,110.00)
27.05 ($1,065.00)
28.11 $0.00
29.00 $890.00
29.89 $0.00
30.00 ($110.00)
30.53 ($110.00)
34.02 ($110.00)
37.50 ($110.00)

What is appealing here is that even if (T) were to move up above $29.89/share, the most you stand to lose is $110.00. The largest amount of risk is that if (T) fell below $28.11/share. The highest realization of full profit potential is if the stock is trading at $29.00/share.

While I do not generally like weekly options, the 'Butterfly Spread' is one strategy that can work very well here if the stock trades in a tight-range. Here is an example of a weekly 'butterfly spread' trade that you can use with (T) or any number of similar, non-volatile stocks:

2.) Entered Trade- Weekly Expiration (T)

-Buy ten (10) November $28.00 calls

-Sell twenty (20) November $29.00 calls

-Buy ten (10) November $30.00 calls

Price Cost
Buy 10 T Nov11 28 Call $1.21 $1,210.00
Sell -20 T Nov11 29 Call $0.34 ($680.00)
Buy 10 T Nov11 30 Call $0.04 $40.00

Requirements

Cost/Proceeds $570.00
Option Requirement $0.00
Total Requirements $570.00
Estimated Commission $50.00

Profit/Loss Chart:

Current Price: $29.19

Price Profit / Loss
21.00 ($570.00)
24.17 ($570.00)
27.50 ($570.00)
28.00 ($570.00)
28.57 $0.00
29.00 $430.00
29.43 $0.00
30.00 ($570.00)
30.83 ($570.00)
34.17 ($570.00)
37.50 ($570.00)

This weekly trade, as you can see, carries minimal risk. The most you can lose on the trade no matter what it does is $570.00. While the upside is capped at $430.00 on a 10/20/10 distribution, this isn't such a small amount with such a minimal initial investment. Of course you can add or decrease the amount of contracts on the trade.

While the 'butterfly spread' trade isn't for everybody, if you are simply looking to profit off a range-bound stock, this can work very well. I know traders who use this only on a weekly basis and actually make decent money doing so. They place several of these a week and sometimes purchase a lot of contracts with each trade to increase their profit. While the stocks mentioned above work well with this strategy, there are a lot more. if you have any question or comments, I will try to answer them as soon as possible.

Good luck.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Using A 'Butterfly Spread' On These Range Bound Stocks