Butterfly Trading for Beginners: Easy Strategies for Options Success
What is Butterfly Trading?
Options trading often gets a reputation for being overly complex and risky. However, certain strategies are designed to carefully manage risk while offering a chance for profit in various market conditions. Butterfly trading is one such strategy, recognized for its balance of limited-risk and profit potential.
In a nutshell, butterfly trading involves combining multiple call or put options at different strike prices to create a specific profit and loss profile. A butterfly spread typically includes four options contracts:
Long (buying) one option at a lower strike price
Short (selling) two options at a middle strike price
Long (buying) one option at a higher strike price
The strike prices are spaced equidistant from each other, and all options have the same expiration date. This creates a distinctive payoff diagram that resembles a butterfly – hence the name.
Types of Butterfly Spreads
There are five primary types of butterfly spreads, each uses a different combination of strikes but All offer identical risk profiles. The key difference will be in the execution ease. Sometimes the Calls or Puts of an asset will have more open interest. This will allow for a tighter bid/ask spread for those options and potentially a more favorable trade outcome when taking slippage into account.
Long Call Butterfly: Constructed by buying one in-the-money (ITM) call, selling two at-the-money (ATM) calls, and buying one out-of-the-money (OTM) call. This is used when you expect the underlying security to remain relatively stable in price.
Short Call Butterfly: The opposite of the long call, involving selling one ITM call, buying two ATM calls, and selling one OTM call. This is used when you believe the underlying security may slightly decline in price.
Long Put Butterfly: Constructed with put options – buying one ITM put, selling two ATM puts, and buying one OTM put. This is preferred when you anticipate a slight rise in the underlying asset.
Short Put Butterfly: The opposite of the long put, where you sell one ITM put, buy two ATM puts, and sell one OTM put. This expects a moderate decline in the underlying security’s price.
Iron Butterfly: This is a combination of a Bearish call vertical and a bullish put vertical with the same middle strike price. It profits when the underlying asset price stays within a narrow range.
Example of an ATM Iron Butterfly using SPX Options
Why Use Butterfly Trading Strategies
Butterfly trading strategies offer several advantages over simply buying or selling options outright:
Limited Risk: The beauty of butterfly spreads lies in their defined risk. Your maximum loss is capped at the initial cost of setting up the spread. This contrasts with naked option buying/selling, where losses can be substantial for options that move significantly against your position.
Profit Potential in Various Markets: Depending on the type of butterfly spread constructed, you can potentially profit from flat, moderately rising, or moderately falling markets. This versatility makes butterfly trading an attractive proposition for traders who anticipate periods of low volatility.
Ideal for Volatility Expectations: Butterfly strategies are heavily influenced by the trader's outlook on an underlying asset's volatility. If you correctly anticipate low or dropping volatility, butterfly spreads can yield decent returns with controlled risk. Butterflies can be placed OTM “Out of the Money” as well and can even profit from rising volatility if the underlying asset swings increase. This happens many times with trading SPX Options.
Calculating Butterfly Trading Profits and Losses
Understanding the break-even points, maximum profit, and maximum loss is crucial for effective butterfly trading. Here's how these are generally calculated:
Break-Even Points: A butterfly spread typically has two break-even points – one above the middle strike price and one below. These break-even points can be calculated by adding or subtracting the net premium paid for the spread from the middle strike price.
Maximum Profit: The maximum profit is reached when the underlying security closes exactly at the middle strike price on the expiration date. This profit is calculated by subtracting the net premium paid from the difference between the middle strikes and the long strikes.
Maximum Loss: The maximum loss is the net premium paid to enter the butterfly spread and cannot exceed this initial cost.
Example: Let's say you construct a long call butterfly by buying a call option with a 100 strike price, selling two call options with a 105 strike price, and buying a call option with a 110 strike price. If you paid a net premium of $200 to set up the spread, your calculations would be:
Break-Even Points: 103 ($105 - $2) and 107 ($105 + $2)
Maximum Profit: $300 ($5 difference in strikes - $2 premium)
Maximum Loss: $200 (the net premium paid)
How to Execute Butterfly Trades
Most online trading platforms that offer options trading will have the functionality to execute butterfly spreads. Here's the general process:
Choose Your Underlying Asset: Select a stock, index, or another asset on which you'd like to perform a butterfly trade.
Determine Your Strategy: Decide whether you want to use a long call, short call, long put, short put, or iron butterfly based on your market outlook.
Select Strike Prices: Carefully choose the strike prices for your spread, taking into account your risk tolerance and volatility expectations. The strikes should be equidistant.
Choose Expiration Date: Select a suitable options expiration date based on your time horizon for the trade.
Execute the Trade: Many trading platforms allow you to place a butterfly spread as a single order. This simplifies the process by automatically placing all four option orders simultaneously. I provide an example of setting up a butterfly spread in this YouTube Video.
Important Considerations:
Implied Volatility: This is a key factor influencing options prices. High implied volatility can lead to more expensive option premiums, counterintuitively decreasing the cost of setting up a butterfly spread. At the same time, Implied volatility is typically mean reverting. This creates great opportunities to buy butterflies during high relative volatility as an added Edge. This is the beginning of thinking about trading based on the current market environment.
Liquidity: Ensure sufficient trading volume (liquidity) in the options contracts you choose, especially if you plan to trade larger size.
Managing Risk with Butterfly Spreads
While butterfly spreads are designed to have limited risk, they're not risk-free. Here are essential strategies for managing risk:
Accurate Expectations: Butterfly trades perform best when your volatility assumptions are correct. If the underlying asset unexpectedly experiences a rise in volatility, your losses could create exacerbated losses.
Position Adjustment: If volatility changes significantly, you might consider adjusting your butterfly spread by rolling positions or closing the trade.
Stop-Loss Orders: Some platforms allow you to utilize stop-loss orders with options to limit potential downsides if the trade moves against you. A note of warning… options spreads can have flash spread mispricing. This creates a momentary flash of loss or gain that market makers can execute your stop order right at the moment when the spread is erroneously priced.
Advanced Butterfly Trading Techniques
Combining with Other Strategies: Butterfly spreads can be used strategically in conjunction with other options strategies. For instance, combining a butterfly spread with an iron condor creates an iron butterfly, offering a wider profit zone with reduced premium costs.
Variations: Beyond the standard three-strike butterfly, traders can experiment with spreads using more than four option legs. This creates different risk-reward profiles with greater customization potential. We do this in many of our trades in our ADAPT Daily trades. See image below
Is Butterfly Trading Right for You?
Butterfly trading may not be suitable for everyone. Here are some factors to consider before utilizing these strategies:
Risk Tolerance: Even with limited risk, butterfly trades can still result in losses. Evaluate your risk tolerance and ensure you understand the potential for losing the initial premium paid.
Trading Experience: Butterfly trading requires a good grasp of options concepts and how these strategies work in different market conditions. It's generally more suitable for traders with some options and experience.
Market Outlook: Butterfly trades are heavily reliant on your ability to anticipate volatility. If you are uncomfortable forming views on an asset's future volatility, these strategies might not be the best fit.
Case Study: The ADAPT Daily Strategy
The ADAPT Daily Strategy is tailored specifically for trading butterflies on the SPX (S&P 500 Index). It's designed as a "set-and-forget" approach, emphasizing simplicity.
Here's a broad overview:
Premise: The strategy capitalizes on the historical tendency of SPX to experience lower volatility near term compared to further out expiries.
Trade Structure: Selling short-term butterfly spreads and simultaneously buying longer-term butterfly spreads to take advantage of volatility discrepancies.
No adjustments: The strategy typically involves holding trades to expiration without the need for active management.
Important: As with any trading strategy, it's vital to fully understand the risk and potential rewards of the ADAPT Daily Strategy prior to implementation.
Conclusion
Butterfly trading offers a compelling option for traders seeking to balance risk and reward within the complex world of options strategies. With a defined risk profile, potential for profit in diverse market conditions, and flexibility for customization, butterfly spreads hold a valuable place in the options trader's toolkit.
Key Takeaways:
Butterfly spreads involve combinations of calls or puts with varying strike prices, creating a distinctive profit/loss profile.
These strategies are ideal for traders with an outlook on low or stable volatility.
Thoroughly understanding break-even points, profit potential, and maximum loss is crucial.
Risk management techniques, including accurate volatility forecasting and stop-loss orders, are important for controlling downside potential.
Important Reminder: Trading options carries inherent risks. Before implementing butterfly spreads or any options strategies, it's essential to conduct your own research, develop your options trading skills, and carefully consider your individual risk tolerance.
