As often discussed on the tastytrade network, an important component of portfolio management involves diversification.
If we only have one position, or trade a single underlying, then our risks become concentrated and intensified - much like going to the casino and simply putting "everything on red" at the roulette table.
One way that traders can diversify their portfolios is by deploying a wide range of strategies (aka position types) in their portfolios. For example, a trader might deploy vertical spreads, calendar spreads, iron condors, and jade lizards - all of which have been discussed extensively on the tastytrade network.
For traders that are looking to learn more about diversification by strategy, we are featuring on the blog today the butterfly spread, which was featured recently on an episode of The Ryan & Beef Show.
Much like other options-based strategies, the butterfly can be deployed to fit a variety of outlooks - particularly if a trader is expecting little to no movement in an underlying stock, or if a trader is expecting significant movement in an underlying (but isn't sure exactly which direction).
First, let's briefly outline the mechanics of a butterfly spread. The butterfly is constructed using three different strikes within a single expiration period (all calls or all puts). It's imperative that the distance between the strikes be exactly the same.
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).
Likewise, 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 both purchased, or the reverse.
If you’re a longtime tastytrader, you can probably imagine what outcome a trader might be expecting with both types of butterflies - especially given that the middle strike contains twice as many contracts.
When selling the body of the butterfly, a trader is hoping that the underlying remains as close as possible to the middle strike, with the long wings representing insurance in case the underlying makes a big move.
When purchasing the body of a butterfly, 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.
If a big move does occur, the sale of the wings cuts into potential profits, which is 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 for a butterfly spread.
One of the most confusing aspects of butterfly spreads actually relates to the naming convention as opposed to the actual 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 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.
That means that a "short" butterfly performs best when the underlying breaks through the short strikes at 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.
At the end of the day, the most important thing is that you understand the risk profile of the position you are planning to deploy and that it matches your outlook.
The graphic below illustrates the theoretical P/L of a “long” butterfly spread, which involves selling the body (100 strike), and purchasing both wings (95 and 105 strikes):
The above chart also provides a good segway into a more detailed examination of the P/L profiles of both long and short butterflies.
As stated above, a "long" butterfly produces its maximum profit when the underlying expires right at the short strike. The max profit can be calculated using the formula shown below. On the other hand, the maximum loss from a long butterfly is slightly less complicated to calculate - it is equal to the sum of the net premium paid + the net commissions paid, also shown below:
Long Butterfly: Max Profit = Strike Price of Short Call - Strike Price of Lower Strike Long Call - Net Premium Paid - Commissions Paid
Long Butterfly: Max Loss = Net Premium Paid + Commissions Paid
Switching gears, a "short" butterfly produces its maximum profit when the underlying breaks through either of the strike prices at the wings of the spread.
The maximum profit of a short butterfly is the net premium received for the spread less any commissions paid. The maximum loss for a "short" butterfly occurs when the underlying expires right at the long strike and is calculated below:
Short Butterfly: Max Profit = Net Premium Received - Commissions Paid
Short Butterfly: Max Loss = Strike Price of Long Call - Strike Price of Lower Strike Short Call - Net Premium Received + Commissions Paid
While we have provided an overview of the butterfly spread on this blog post, there is an extensive amount of material on the tastytrade website that is available to traders seeking to learn more about this dynamic spread.
One such piece examines varying widths between the strikes of some sample butterfly spreads, and can help traders gain additional perspective on how to structure potential trades. The link to that show, and several others focusing on butterfly spreads are listed below:
If you have any outstanding questions on butterfly spreads, or any other trading-related topic, we hope you’ll leave a message in the space below, or send us an email at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.