Where vertical spreads require you to have an opinion just on direction, a butterfly requires more precision because, not only do you have to have an opinion on direction, but also a target price. Essentially, a butterfly is a combination of a vertical bull spread with a vertical bear spread using either all calls or all puts. “The way a butterfly is formed is by buying an in-the-money and an out-of-the-money call or put, and then selling two calls or puts at the middle strike,” which is your price target, Burgoyne says.
One reason a trader may use a butterfly over a vertical spread is because it is usually cheaper, Kearney says, because you are selling two options. This changes the risk/reward ratio.
Looking again at Kearney’s $63 stock, if we think it will be at $70 at expiration, a butterfly could make a lot of sense. To put it on, we again buy the 60-70 vertical bull call spread by buying an in-the-money 60 call and selling an out-of-the-money 70 call, but we then add a 70-80 vertical bear call spread by selling a second out-of-the-money 70 call and buying an out-of-the-money 80 call.
In this example, our reward is maximized if the stock settles at $70 on expiration, in which case our 60 call is 10 points in-the-money and the other three calls all expire worthless. Even if it doesn’t settle at $70, as long as the stock increased in value, our butterfly still could be profitable within a range of prices. If the stock either stagnates or only rises a little, or if it takes off and completely overshoots our $70 target, our loss is limited to the cost of the butterfly because of the wings on either side. “The risk/reward on a butterfly usually is very good,” Kearney says. “Once again, though, we have four commissions entering the trade and two to four on the way out, so it is commission-intensive.”