The butterfly option is a three-legged (with a total of four options) option trade used primarily when an options trader has a distinct opinion of where he believes a stock will trade at a specific point in time. The options trader can monetize his strong view by risking a relatively small amount of money to yield gains in excess of 100% should his view prove correct over the term of the trade.
How To Structure a Butterfly Option
A long butterfly option can be thought of as the combination of a short straddle and a long strangle option. The options trader, in accordance with his stock thesis, would short 2 calls (or puts) at the strike he believes the stock will trade around at the options’ expiration. Obviously selling a naked straddle would expose the options trader to substantial risk, actually unlimited risk due to the naked call portion of the straddle which is unbounded. To alleviate upside and downside risk, the options trader buys a strangle option with strikes wider than the strike of the straddle. The strikes of the butterfly option are typically evenly spaced as illustrated in the payout diagram below. The long strangle option caps the potential loss of the long butterfly option trade, and thus the max loss and gain of this particular option trade is known at the outset of the trade, making a lot of risk managers very happy.
Sample Risk Profile of A Butterfly Option
In the example above the options trader purchased the February 550-570-590 butterfly option in Google (GOOG) consisting of a long 550-590 strangle option and a short Feb 570 straddle. You can also view this option trade as a long Feb 590-570 put spread and short 570-550 put spread, either way is fine, whichever way is easiest for comprehension. With shares of GOOG trading around $585 at the inception of this option trade, the options trader was clearly bearish on shares of GOOG through February expiration. The options trader ends up paying $250 for the chance to make $1750 (a 700% return!) should shares of GOOG trade at $570 upon expiration. That’s a remarkable return but one has to consider just how likely it is for shares of a highly liquid technology stock to trade at a set specific price weeks in the future (has to be severely low). The max loss on the trade is $250 should shares of GOOG trade above $590 or below $550 upon expiration. The butterfly option trade in this example yields a profit with shares of GOOG trading between $552.50 and $587.50.
Other Ways to Profit From a Butterfly Option
In the example above we assumed the options trader would hold the GOOG butterfly option until expiration to achieve maximum profitability. However the options trader doesn’t necessarily have to hold the position until expiration to yield a profit. Since the butterfly option is inherently short volatility, should the implied volatility of the short options decline the options trader could close out of the trade at a profit prior to expiry. If implied volatility increases the option trade could show a paper loss in excess of the maximum loss indicated above. Just remember this is a paper loss and the butterfly option still would only result in a $250 loss at worse if held until expiration.
For further information on the Butterfly Option and other Options Trading Strategies visit OptionsUniversity.com.
