From the May 01, 2012 issue of Futures Magazine • Subscribe!

Using directional butterfly spreads to express an opinion

All done with safety and precision

QUESTION: How can you exploit the safety and precision of butterfly spreads to express an opinion on the market?

ANSWER: Use a directional butterfly spread.

Butterfly spreads, generally, are neutral options strategies. The spread can profit when the underlying stock basically goes nowhere. The long butterfly spread involves selling two options at one strike (body) and purchasing options equidistant above and below from the sold strikes (wings). The short options will lose time value and the long options act as protection. Generally, butterflies are composed of either all calls or all puts.

However, butterfly spreads can be used directionally by moving the body of the butterfly out-of-the-money (OTM) and using wide strike prices for the wings. This lets the trader make a directional forecast on the stock with a large profit zone depending on the size of the wings. A bullish directional butterfly can be constructed with calls and a bearish directional butterfly can be constructed with puts, but they don’t necessarily have to be. An advantage to using calls for a bullish outlook and puts for a bearish outlook is cheaper options. Buying OTM options is less expensive and often has tighter bid/ask spreads, which can lower the cost of the trade. 

The idea behind the trade is that the trader has a general price target for the stock and a time frame for the stock to reach it. That can be difficult enough, but a butterfly can provide some margin for error and still profit. The goal of the trade is to benefit from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value and the lower strike call on a long call butterfly or higher strike put on a long put butterfly have intrinsic value.

To begin constructing a directional butterfly, a trader will have to forecast where a stock might be trading and how long it will take to get there. If the stock has been volatile, it might make sense to use wider strikes to have a larger margin of error and increase the chance of success. The more the trader expands the wings, the more the butterfly will cost, but the trader benefits by having a larger zone potentially in which to profit. Using tighter wings lowers the cost of the spread but gives the trader a smaller potential profit area. On a less volatile stock, such as Johnson & Johnson (JNJ), a tighter gap between strikes may increase the chance for success and profit.

Here’s an example using Apple Inc. (AAPL). It’s near the end of March and Apple is trading in the $600 area. The trader thinks that by May expiration the stock will trade in the $650 area but would like some margin for error because Apple has been volatile. The trader decides to spread the butterfly’s wings out by $30 on each side of the $650 body.

The trader will: Buy one May 620 call for $24, sell two May 650 calls for $13.50 each and buy a May 680 call for $7. The total cost of the spread will be $4 (plus commissions), which is the most that can be lost if AAPL is trading at or below $620 or at or above $680 at May expiration. The maximum profit is determined by subtracting the cost of the trade from the difference in the wing strikes which in this case is $30. The maximum profit in this example is $26 ($30 strike difference – $4 debit). This would be achieved if AAPL trades at $650 at May expiration.

Because the butterfly has two wings, there are two break-even points. Add the net debit to the lowest strike and subtract the net debit from the highest strike. For this example it is $624 (620 + 4) and $676 (680 – 4). If AAPL trades between $624 and $676 at May expiration, the trade will be profitable. Anywhere outside of that area and the trade will not be profitable. Note that even though this example uses calls, a long put OTM butterfly can be used if a trader is bearish on the stock.

A drawback of the directional OTM butterfly is that its long and short options usually retain their time value. The OTM butterfly reaches its maximum profit potential close to expiration when most of the time value is gone. In other words, a trader will have to be patient. Directional OTM butterfly spreads offer an option trader bullish or bearish exposure to the market while managing risk and retaining large potential returns. Even though butterfly spreads cannot offer unlimited profit potential, they usually cost less than buying outrights. Let a butterfly spread its wings and fly to an area where it can profit. 

John Kmiecik, an option trader with more than 20 years of experience, is an instructor at Market Taker Mentoring LLC.

About the Author

John Kmiecik has worked for several firms, including Goldman Sachs and First Options of Chicago, and has traded professionally for hedge funds. Currently, he is an options coach for Market Taker Mentoring LLC. E-mail him at john@markettaker.com.

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