- Bigtrends - https://www.bigtrends.com -

OK, But What’s a Butterfly Spread?

On Wednesday afternoon we featured an article penned for Investors.com [1] – the website of Investors Business Daily – explaining how Advanced Micro Devices (AMD) shares had the makings of an ideal butterfly spread trade. Author Gavin McMaster then went on to explain in some detail what he was seeing and why he was trading it the way he was. And, he did a great job of doing so.

His commentary, however, raises a handful of questions. Chief among them are how exactly do they work, and what might an options trader want or need to know about these types of trades before placing one for themselves.

This one's for you.

In simplest terms, the typical butterfly spread is a type of neutral options strategy, meaning they are designed to profit from small changes in the price of the underlying asset. They are typically used when a trader expects the underlying asset to trade within a narrow range over the life of the options, and generate income at their onset by virtue of being a net. They're not great trades if you're anticipating an explosive move; that kind of outlook is monetized by being a net buyer of contracts. We'll cover this type of trade at a later time.

The mechanics: A conventional butterfly spread involves buying one option at a lower strike price, selling two options at a higher strike price, and buying one option at an even higher strike price. All options have the same expiration date, and the strike prices are equidistant. (In most regards it's the equivalent to taking on two different conventional spread trades at the same time.)

As always, an example will help illustrate how and why the strategy works.

Let's say option trade Larry believes XYZ stock is set to settle for a while right around a price of $200 per share. To act on his assumption he would enter a long call butterfly spread. He writes, or sells, two call options at a strike price of $200 and buys two call options at $190 and $210.

Net cost? $1… paying $6 and paying another $3, but collecting $8 of that amount back,

The goal here, then, is to do nothing until nearer expiration and hopefully close out or unwind the trade on much better pricing terms. The two XYZ calls with strike prices of $200 will ideally expire worthless, but if Larry has to buy them back, he could likely do so very cheaply. One of the other two owned calls will most likely have some value at expiration, but the other won't; we don't know which is which. But, we don't entirely care either. What we do know is Larry will be able to do something with one of the two.

The maximum potential gain on closing out this trade is the $10 difference between the center strike prices of $200 and either of the other two strikes of $190 or $210, MINUS the $1 cost for entering the trade…. $9. Just for the record though, option pricing rarely allows you to achieve this maximum potential profit. Conversely, the maximum potential loss here is the $1 cost of entering the trade (and you should know that's a bargain price as well… most butterfly spread's potential profit tends to be closer to its potential net loss.)

Confused? It's understandable if you are. These types of trades require a few hypothetical run-through — or "paper trades" — to really get a grip on them. Try a few for yourself to get a feel for how they work before committing actual money to the strategy. In the meantime, here's the bottom line of what you need to know about butterfly spreads.

Advantages:

Disadvantages: