To understand advanced option strategies, all you really need to do is make sure you have a solid foundation in the basics and then build on it. A good example is the long butterfly, a conservative strategy that makes money when things don't change much.
There are several ways to conceptualize the long butterfly. Let's do it by starting with the most basic of options, a simple call. With ABC stock trading at 55, a 3-month 55 call is going for $3.25. You'd like to structure a trade based on the thinking that ABC is going to stay extremely close to 55 during the next 3 months, but you want to minimize your risk if you are wrong.
At-the-money options have the most pure time value, so you're going to want to sell these 55 calls.
But you're not trying to play that ABC will go down. How about this? Buy call options on ABC that have, on average, the same strike as the ones you are selling. It turns out that the in-the-money 50 calls cost 6.75, while the out-of-the-money 60 calls are offered at 1.25.
You decide to buy a single 50 call, sell 2 calls with a 55 strike, and buy 1 call with a 60 call strike. The total outlay, before commissions, is 1.50 [6.75- (2*3.25) +1.25]. This outlay represents your total exposure.
The worst outcome - losing 1.50 - comes with the stock closing below 50 or above 60. A profit, before commissions, occurs between 51.50 and 58.50. The highest profit - the position worth 3.50 - occurs with the stock completely unchanged at 55. The potential return on risk capital here is terrific - more than 130% - but the high returns take place for a fairly narrow range of stock prices. Still, even between 53 and 57 on this trade, the returns are at least 100%.
This example shows both the benefits and drawbacks of a long butterfly. The good points are that losses are limited and small relative to potential upside. The main drawback is simply that the stock needs to be in a fairly narrow range to experience the best outcomes. There is also a slight technical difficulty that can occur with the ideal outcome.
Looking at the chart, it's evident that a butterfly is nothing more than 2 call spreads pasted together - a 50-55 debit spread and a 55-60 credit spread. The best outcome for the debit spread is 55 or higher, while 55 or lower is ideal for the credit spread. Combining the 2 means that having the stock as close as possible to 55 produces the optimal outcome for this long butterfly. The logic of the trade, as noted earlier, is to sell the options that have the most pure time premium, since they stand to lose the most value if the stock does not move.
It may not be immediately clear why a long butterfly spread should always result in a net debit (cash outlay). As the strike price moves higher, each 5-point (or any increment) call spread should be worth somewhat less than the previous one. For instance, with ABC stock at 55, consider the following set of 3-month call options.
One word of caution: if the stock is very close to the middle (55 in this example) strike price near expiration (which is the ideal outcome) - you will probably need to take action to unwind the trade. This is because you are short 2 of the at-the-money calls and you cannot be certain what action the owner of those calls will take. To make sure you do not end up with an unwanted position the following week, you are advised to sell your in-the-money calls and buy the calls you are short. The slight additional commissions and premium you will have to pay should not be much of a problem, since things have essentially turned out as well as can be.
Finally, butterfly spreads can be implemented just as easily for puts as for calls. We have simply used calls hear to simplify the exposition. But if you own a put and decide your opinion has changed, you may find it advantageous to turn the put into a butterfly by selling two puts at the next lower strike and then buying a put one strike below the ones you sold.
Short Butterfly
In a short butterfly, you are expecting the stock to be fairly volatile between the time you enter the trade and when the options expire. Unlike many trades where you expect high volatility, this trade is unusual in that it actually involves a credit to you. Let's use the same numbers as for the long butterfly above.
When you write (or sell short) the butterfly, you sell each of the "wings" once while buying the middle twice. So, from your sales you would collect 8.00 (6.75+1.25) for selling a 50 call and a 60 call, while you pay out 6.50 for two of the 55-strike calls.
We can see that your worst-case scenario is for the stock to be right at 55 at expiration. At that point, the options you bought are worthless, while you will have to pay 5 points plus slippage and commissions to cover the short 50 call. So after collecting 1.50, which is the most you can make on the trade, you end up having to pay out 5 for a 3.50 loss.
On the other hand, you can collect your 1.50 (representing a nearly 43% return on the 3.50 you risk) . First, if the stock goes down sharply so that all options finish out of the money, you will walk away with your whole profit. In the case of a call butterfly, this has the additional advantage of not having to worry about any commissions or exercise fees at the end.
On the upside, if all options finish in the money, you also maximize profits. If the stock has gone comfortably above the highest strike price, you simply exercise your options, since the stock you get will be immediately called away by the owner of the middle strike. You can, of course, unwind the whole trade, but then you will be subject to slippage and commissions on the way out.
This actually suggests a good thing to keep in mind if you think selling a butterfly makes sense. If you think the stock is more likely to trade sharply lower than higher, write a call butterfly. Write a put butterfly (same strikes, same strategy, just do puts instead of calls) if you think a move to the upside is the likeliest event. Market makers will keep the prices of the two approaches roughly in line with one another after adjusting for financing costs. If you are right, this will give you the greatest chance of not only making money but also minimizing trading costs.
Long Iron Butterfly
One of the key principles behind option trading and pricing involves the concept of "no arbitrage." This means that in the absence of strong technical deficiencies, such as the unavailability of stock to borrow, options must be priced such that there are no risk-free profits available.
The biggest implication of this concept is commonly known as "put-call parity." What this essentially means is that you can construct economically identical trades in virtually all cases using either calls or puts. This may sound counterintuitive, but apart from directionality, calls and puts of the same expiration and strike price are actually identical creatures. You can, for instance, turn a put into a call simply by buying the underlying stock.
Because of all this, there's a way to create a long butterfly spread with minimal net cash outflow at the beginning. It's called the "iron butterfly" and it involves substituting a put credit spread for a call debit spread at the lower strikes. Put-call parity assures that the 2 trades will have the same economic outcomes for any given stock move.
Before you read further, take a moment to remember why you may want to put on a long butterfly. You don't expect the stock to move much, if at all, and you want to make a large return on your capital if you're right. At the same time, you want to know your maximum loss from the start, and you want it to be manageable. Once again, here are our example numbers:
Now, you write a put credit spread by selling the 55 strike and buying the 50 strike, taking in 1.50 (2.75 - 1.25) net. Against this, you write a call credit spread, again using the 55 strike to write, but buying the 60-strike call. This will net you a 2-point inflow (3.25 - 1.25).
Your total inflow is 3.50 (1.50 + 2.00). Against this, you will generally be required to post 5 in margin, representing the maximum amount it can cost you to close out the trade at expiration. To review again, you will have to pay that 5 points if the stock is either below the lowest strike or above the highest strike.
Your premise that the stock would not move much was incorrect in this case, and one of the spreads you sold will go to its maximum value (the difference between the strikes) while the other spread becomes worthless.
You should be able to see that because of the required margin, the 3.50 inflow is something of an illusion, and the economic reality of the trade is that you need a net 1.50 in capital (5 - 3.50) to initiate the position. This is the same amount you would need to initiate the plain-vanilla butterfly spread.
