The butterfly spread is a conservative strategy with both limited profit potential and limited risk. It is actually a combination of a bull spread and a bear spread. It canbe constructed using all calls, all puts, or a combination of each.
Three strikes are used: one high, one low, and one in the middle. You buy the upper andlower strikes and sell the middle strike.
For example, suppose a stock is selling at 50 and your option pricing model indicates the 50 strike front month options are "rich" and should be sold. Your opinion on thestock is neutral. You sell the 50s and buy the 45 and 55 strikes.
Another way of looking at the butterfly spread is selling a straddle and buying a strangle: Selling the50 strike straddle and buying the 45/55 strangle, in this example.
If you took in a net credit of $3.50 per spread, that is your maximum possible profitfor selling the spread.
The risk is the difference between strikes (5 points) minus the credit received (3.50)or 1.50 points per spread. Not bad.
Your profit range, in this example, is the middle strike (50) plus and minus the creditreceived (3.50): 53.50 - 46.50.
The risk is limited should the underlying fall below the lowest strike or rise above thehighest strike. The maximum profit, as in all strategies involving the selling of optionpremiums, is at the strike price of the options sold. In this case, the middle strike.
Should the underlying experience a large move in either direction, some strategists close out the profitable side of the butterfly spread near its maximum profit point thus preparing to capitalize on a price reversal, should one occur.
Caveat: In this, or any, strategy involving the shorting of options, avoid early assignment by closing the position if the short options trade in-the-money, at or near parity.
Always keep in mind the "time value" of money. By that I mean consider closing the position early if most of the potential profit has been earned and there remains aconsiderable amount of time left till expiration.
For instance, if you find that you've earned more than half of the maximum potentialprofit in less than half the time to expiration, is it wise to stick around for the smallremaining profit?
Suppose, for example, you're ahead 80% of the maximum possible profit in less than 50% of the time remaining. Do you really want to stick around for the remaining 20% and risklosing back the profit that you've already earned?
The butterfly spread is a favorite strategy of many traders.
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