How to Construct a Butterfly Spread
Talks about the option spread known as the Long Butterfly. Learn about Theta, decay rates and times to use this spread such as over earnings. We also go over basic options adjustment techniques when dealing with the options butterfly strategy.
Hi there everybody! This is Morris form San Jose Options. Today, we’re going to talk a little bit about the long butterfly option strategy. Over the years, this has been one of my favorites. Typically, I use the unbalanced butterfly style or broken wing but first we’re going to talk a little bit about your basic at-the-money, long butterfly.
This strategy is a limited profit, limited risk strategy that involves 3 different strikes. You’re going to be selling the strike in the middle. This could be constructed with calls and puts or just calls or just puts. When you construct the spread, it’s going to look something like this. And you’ll buy one over here and then you’ll sell two in the middle and then you’ll buy one over here. Typically, this will be at-the-money, right in the middle. The goal in this type of trade is to make money as the underlying goes sideways. You’ll be looking for something that maybe forming a neutral type of channel and something that’s not too volatile and kind of stays within that kind of channel as you go through time. If you do that, then this strategy can be very rewarding. This could be done with calls, where you would have a long call, 2 short calls and one long call here. You can also do this with all puts, where you have a put, 2 short puts and a long put. Or you can actually have a put, a short put, a short call, and a long call. There’s different ways to do it. If you do it using puts and calls, then they typically call it an iron butterfly. Those are just some basic terms.
Let’s move down and see what else we can discuss. When to use the butterfly spread? We talked about this a little bit. If you think that your underlying asset is really going to go sideways for a decent amount of time but I’ll also talk about another way to make money with this type of trade. And that’s when you think volatility of your underlying is going down. If you know, the volatility is going to drop, then, you can make some money with this spread. One thing we like to do is in at-the-money butterfly over earnings. Typically, over earnings, you’re guaranteed that the volatility is going to drop on your underlying asset. This is one of the strategies that we do sometimes, on our course and we do these butterflies at-the-money or slightly out of the money or broken wings over earnings. To do this, obviously, it helps to have some statistics and that’s one feature that we actually have in our course. We have an instant back tester for you to help you with earnings that’ll actually scan through them, back test and everything for you and we could do, for example, 4,000 back tests in about 1 minute to help you pick those out.
This is a great way. Sometimes it works, sometimes it doesn’t. The key is to find your underlying that tends to not move so much over earnings. You’re looking for once it moved maybe, let’s say, less than maybe 5%. If you find these symbols like apple, apple tends to work really well. But if you find ones that move about 5% or less over earnings and then the volatility drops, let’s say, 20 to maybe 30%, we drop over earnings they typically make pretty good return. That’s just another time that you might use this type of strategy. Profit expectations, your profit are going to be maximized when you’re right in the middle of that butterfly. Again, if it’s with calls, it’ll be right at the short call. If you’re doing puts, it’ll be right at that short put you get towards the expiration. Not easy to do but, I mean, certainly could happen if you do a lot of them.
Typically, with this spread you’ll probably exit before expiration. It may not be wide enough to go into expiration unless you do a really wide one. Maximum profit must get into, let’s see, the breakeven. You’re going to have 2 breakeven points with this spread. Typically, it’s going to look something like this. You may have a zero line and it comes right through and you’ll have your breakeven here and a breakeven here. Anywhere between this point and this point is going to be a profit. Outside, over here, which is this zone here and then that zone there will be a loss. You have to finish above the zero line. Basically, all this would be profit. This would be a loss and then over here would be a loss on the trade. Typically, at expiration, it’s about maybe 40% wide probability, or POP we call it: probability of profit at expiration. That’s going by your black shawls formula in typical pricing models using the standard deviations. It is a rather low probability trade. The payout could be pretty high if you happen to stay towards the center of that butterfly.
Let’s talk a little bit about managing the trade. Obviously, if you don’t adjust the trade, then you could realize that maximum loss. I’ll just show you some basic adjustments, maneuvers you could do. Let’s say you have your butterfly here and let’s say you start in the middle, so this again is like your zero line. Let’s say the underlying starts to go this way. As the underlying goes this way, you can take some of this side off and you can raise this leg right that and it’s going to help flatten it, your delta, and help protect this side so you don’t lose all the way down here because you raised it up to here, for example. There’s different ways you could do it. You could take off part of this spread or you could actually add to this spread, make this come down farther and then that’s going to tilt it. It’s almost kind of this tilting back and forth, back and forth and you’re trying to balance that trade out and keep the delta rather flat. If the market went this way, you could do the opposite where you could take off some of this, move this side up higher or drag this side down lower and again balance at your delta so you minimize your risk.
In most cases, you won’t realize a maximum, most cases you won’t have this maximum or this maximum but you can certainly have some decent losses especially if the market whips ours around, then you’re kind of titter tottering back and forth all the time. That could be the tough part of the trade. But if it does trend one way, then you could keep doing your adjustment and have really not a lot of loss on it which is kind of nice.
The key behavior will not show up until the final month. There is an interesting topic, again, about decay. When you’re talking about decay rates, when they’re at-the-money, they’re actually not really that fast. You have, in this particular spread, you have your short contracts here and then you have your long ones to the sides, where this is at-the-money in the middle. Your at-the-money is actually going to decay slower than these outside contracts. That’s what so interesting about this spread because you have a positive theta and even though this is close to the money, it has the highest theta possible because it’s right at-the-money. However, it’s decay rate, and it’s something we really get into in our program, but your decay rate here at-the-money is lower. You have a higher theta, so theta is higher but your decay rate is actually slower right here at-the-money. In this case, if you’re doing an iron butterfly, you would have, again, you would be short a put, short a call, long a put, long a call, and this one here is going to be decaying faster than this one and this one’s going to decay faster than this one too. Your middle decay is the slowest but it has a higher price and it has more thetas. The overall trade has higher theta but if you actually look at the decay rate of each of the strikes, the middle part is decaying the slowest. These decay first and then you’ll get this, that’s why you get this thing that kind of curves down. It’ll kind of curve down here because this one loses its value so does this one. And then toward the end, the middle part decays and then this will go up to the top part the last week or so of the trade because this is the last part that should decay at that slowest decay rate.
Very interesting trade. Covered a lot of things here, negative vega: you can make money on this when volatility drops up here to like the one other thing that you can think about is the way it talks about how the time decay doesn’t show up to the last month. That’s ‘cause this last part actually decays over here at the money but just remember that, I mean, the trade could make money one month out, for example, or even two months out. Go ahead and test them over earnings and you’ll find out. The reason is is because of volatility. Remember, with your option pricing model, the volatility’s the strongest factor in that pricing model. As volatility drops, you can actually move all the way up to the top of the butterfly really fast. You don’t have to be at expiration. You can just maximize a profit or get close to it or at least 20-30% sometimes, even if the trade’s out a month or two, if there’s just a collapse in volatility.
This is, the time decay thing, is true but remember that volatility can certainly play a very important role with this type of trade.
There you have it. Hope you enjoyed that tutorial on the butterfly. Remember for more information, go to sjoptions.com and we’re also working on some amazing software for you guys that has a tool that no other platform in the world has. Check us out and have a good night. Good luck with your trades! Thanks for watching this tutorial.