While luckbox magazine’s Financial Fitness columnist Dr. Jim Schultz has been known to tear up the occasional phone book as a part of his body-building regimen, he recently focused his attention on breaking down a completely different subject—butterfly spreads.
And for anyone who’s been considering adding the butterfly spread to their trading skillset, they will find that Dr. Schultz’s explanation helps simplify what previously may have seemed like a complicated undertaking.
First, let’s briefly review the structure of a butterfly spread. The butterfly is constructed using three different strikes within a single expiration period (all calls or all puts). And it’s imperative that the distance between the strikes be exactly the same.
Much like other options-based strategies, the butterfly can be deployed to fit a couple different outlooks, particularly if a trader is expecting little to no movement in an underlying, or if a trader is expecting significant movement in an underlying (but isn’t sure about which direction).
The key with a butterfly is that twice the amount of contracts are traded on the middle strike (the “body” of the spread) as compared to the outer strikes (the “wings” of the spread), equating to a ratio of 1-2-1.
Along those lines, the body and wings of a butterfly will be a mix of short and long premium – which is where the “spread” component of the position factors in. Either the “body” is sold twice and the “wings” are each purchased once, or vice versa.
Longtime traders of volatility can probably imagine how a butterfly might be structured based on an outlook for limited volatility versus an outlook for heavy volatility, especially because the middle strike contains twice as many contracts.
When selling the body of the butterfly (and purchasing the wings), a trader is likely expecting that the underlying will remain as close as possible to the middle strike, with the long wings representing insurance in case the underlying makes a big move.
On the other hand, when purchasing the body of a butterfly (and selling the wings), a trader is hoping that the underlying moves as far away from the middle strike as possible. The wings are sold to help finance this long premium bet in the event the stock sits still.
The existence of the wings helps explain why a butterfly spread falls into the “defined-risk” category of positions (limited risk, limited reward), meaning maximum gains and losses are known prior to deployment.
One of the most confusing aspects of butterfly spreads actually relates to the naming convention as opposed to the risk profile of the position.
Butterflies are classified as “long” or “short” depending on the exposure of the wings. For example, a “long” butterfly spread involves selling the body and purchasing the wings.
What’s confusing is that “long premium” in the options universe usually means the position theoretically does well when the underlying makes a big move. In the case of the “long” butterfly, the position actually performs best when the underlying sits right on the short, middle strike.
Alternatively, that means a “short” butterfly performs best when the underlying breaks through the short strikes of the wings. Again, that’s slightly confusing because options traders typically think of “short” positions as those in which they want the underlying to sit still.
It’s imperative to keep these nuances in mind when working with butterfly spreads.
Circling back to strategic approach, the first step when considering a butterfly is to decide whether the trader’s outlook best fits a long butterfly or a short butterfly. Next, the trader will need to decide the width (distance of strikes) between the “body” and “wings.”
This is where Dr. Jim Schultz’s insights really bear fruit. On a recent episode of From Theory to Practice, Dr. Schultz provides a detailed explanation of the key factors traders can consider when choosing the width for a given butterfly spread.
Importantly, the discussion not only encompasses the potential rewards associated with a given width, but also the potential risks.
Traders looking to learn more about butterfly spreads will also find an extensive library of information available in the tastytrade LEARN CENTER.
Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of luckbox, tastytrade or any affiliated companies. Readers can direct questions about any of the topics covered in this blog post, or any other trading-related subject, to firstname.lastname@example.org.