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Butterfly Basics – Options Trading In A Creative Way

Jan. 05, 2014 12:33 PM ET
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Seeking Alpha Analyst Since 2011

Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT Press); and "Options for Risk-Free Portfolios" and "Options for Swing Trading" (both Palgrave Macmillan). Thomsett also writes for www.TheStreet.com and the StockCharts.com Top Advisor Corner 

When traders begin checking out the many ways to use options, the spread presents the greatest opportunities, as well as challenges. But don't let the gentle names fool you. For example, the butterfly sounds like a soft, gentle strategy, but it might not be after all.

The butterfly is a complex strategy, so complex in fact that it might not provide enough profit potential to justify it. The position is made up of a bull spread and a bear spread, opened on the same underlying security at the same time. This tends to limit risk and requires very little net payment. But in exchange for this limited risk, maximum profit is limited as well. The ideal outcome takes place when the underlying price does not move too far or too fast.

You might prefer butterflies over other spreads as long as you want to limit maximum loss in exchange for also limiting potential profit.

In the butterfly, you are going to use three strikes. For example, a stock closed at $80.27. You could set up a call butterfly with the following positions:

Buy 1 July 77.50 call $ 4.30

Sell 2 80 calls at 2.31 each - 4.62

Buy 1 82.50 1.04

Net cost $- 0.72

The butterfly in this example cost $72 (plus transaction fees). Although this example used calls only, you can also create a butterfly using puts. In either case, you end up with a small middle zone profit, and outer loss zones above and below.

In the case of buying a 77.50 and an 82.50 call and selling two near at-the-money 80 calls, a trader will lose $150 at the most, or earn a profit of $250 at the most:

Price per 77.50 call 2 80 calls 82.50 call total profit

share profit profit profit or loss .

$75 - 430 462 - 104 - 72

76 - 430 462 - 104 - 72

77 - 430 462 - 104 - 22

78 - 380 462 - 104 - 22

79 - 280 462 - 104 78

80 - 180 462 - 104 178

81 - 80 262 - 104 278

82 20 62 - 104 - 22

83 120 -138 - 4 - 22

84 220 -338 96 - 22

85 320 -538 196 - 22

86 420 -738 296 - 22

In this example, you spend $72 plus transaction costs. You have a change of earning a profit if the stock ends up between $79 and $81 per share. If the price is lower than this, you lose $72; if higher, you lose $22. So the judgment you have to make is whether the exposure to limited loss is worth the opportunity for limited profit.

Realistically, these profits or losses are not always going to be realized. As soon as any of the positions among these three strikes become profitable, that portion of the butterfly can be closed. This occurs on the short side due to time decay or on the long side due to increases in the underlying price above strike. However, this raises a new and unexpected risk. You could end up closing the long sides for a small profit and end up with uncovered short positions. In this case, an assumed conservative trade could result in a leftover that is quite high-risk.

Otherwise, an astute trader will not allow that to occur. In this case, the butterfly can be a low-risk strategy that also offers very limited rewards. You might gain higher profits with less complex strategies including many other types of spreads.

To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. You can take part in discussions among members on the site at the Members Forum.

I also offer a twice-monthly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. Join at Newsletter - I look forward to having you as a subscriber.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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