Butterfly Options Strategy: Enhancing Risk-Reward Ratio

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In this article we are going to discuss another options trading “income” strategy called the Butterfly. There are actually two strategies which fall into this category the “Butterfly” and the “Iron Butterfly”.

The Butterfly is created using either all call options or all put options where you have a debit and credit spread joined At-the-Money by the short strike price of both spreads. The Iron Butterfly is made up of a put option credit spread combined with a call option spread just like Iron Condor except that, once again, the short strike prices of both spreads are At-the-Money.

For example, assuming that IBM is trading at $200, an IBM put-side butterfly centered at the $200 strike price could be put together using an in the money debit spread where  we sell the 200 strike put option and buy the 205 strike put. This spread makes the most money if IBM is at or below 200 at expiration. We now combine this with an at-the-money put credit spread where we sell the 200 strike put option and buy a 195 put creating a credit spread.

This put credit spread makes the most money if IBM is at or above 200 at expiration. When we combine these together we notice that we make the most money if IBM expires right at 200. Assuming in this example that the debit spread costs $3.00 and we received $2.00 for the credit spread, should IBM close at $200 on options expiration day, our credit spread would go to zero allowing us to profit from the $2.00 it was sold for and the debit spread would appreciate in value from $3.00 to $5.00 giving us another $2.00 in profit for a total of $4.00 profit.

Now we will look at the equivalent trade constructed as an Iron Butterfly. We will sell the same put option spread at 200/195 for $2.00. We then sell the call spread using the 200/205 strikes for another credit of $2.00. This gives us a total credit of $4.00 and a risk of $1.00 or 4 to 1 reward to risk. If IBM is at 200 when these options expire, both credit spreads will expire worthless and we keep the entire $4.

So whether constructed as a put side butterfly or an Iron Butterfly (or for that matter a call side butterfly) the trade should yield very similar financial results because of call-put parity.

With reward to risk at such a high level, most income traders choose to exit the trade when returns get to the 10%-20% of risk capital level, allowing them to exit the trades much sooner than expiration in many months if the market cooperates. By exiting early, it allows traders to eliminate market risk and move on to the next trade.

Regardless of the type of butterfly you end up trading, the reward to risk is typically quite good compared to options trading strategies that use out of the money options. This allows the butterfly trader to exit these trades earlier in many cases than the out of the money alternative when shooting for approximately the same return.

Seth Freudberg and Michael Schwartz

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