From the September 01, 2011 issue of Futures Magazine • Subscribe!

Using the broken-wing butterfly options strategy

Spreading the risk

There is investment risk in buying a naked call or put, but by spreading that risk, we can have a more viable strategy. Instead of buying the 530 put naked, you can enhance the position by selling another put at the area you think the stock will stop — in this case, it is the 515 put (our support area).

When buying the 530 put for $18.10 and selling the 515 put for $12.30, you now have on a position costing only $5.80 per share ($18.10 - $12.30). Here, we can make up to the difference between the strike prices of $15, minus the cost of the spread, $5.80. This allows us to have a profit potential of $9.20 on an investment of $5.80 (see "Limiting risk," right).

We still want to trade the equivalent of 100 shares of stock, but our costs have gone way down. If we elected to sell stock short, the cost would be $26,800. With a long put, it would be $1,810. Now, with the put spread, our cost is only $580.

Next in their option strategies education, most traders realize that cost and risk are reduced with the vertical spread by buying one option and selling another. So why not buy one spread and sell another? This is the butterfly spread.

The butterfly spread can be defined as the simultaneous purchase of the vertical spread (call or put) and the sale of the same size further out-of-the-money vertical spread where both spreads share a common center strike.

To explain, we know that the 530-515 put spread costs $5.80 per spread. The 515-500 vertical spread is the same size ($15) spread that is further out-of-the-money. The sale of this spread would bring in $4.40 ($12.30 - $7.90) and help offset the $5.80 cost of our long spread. The butterfly would thus cost us $1.40 (long 530-515 put spread $5.80 debit — short 515-500 put spread $4.40 credit). This is shown graphically in "Butterfly bonus" (right).

We know that if we sell a spread that is further out-of-the-money than the spread we bought, then we can't lose money on the short vertical spread without first making money on the spread that is closer to at-the-money. We are therefore well protected.

We also have taken the cost of entry down from $26,800 to $140:

Strategy Trade outlay
Short stock $26,800
Long put $1,810
Long put vertical $580
Long butterfly $140

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