Setting Profit Traps With Butterfly Spreads

What Is a Butterfly Spread?

The out-of-the-money butterfly spread (OTM butterfly) is one of a range of unique strategies along the option trading spectrum that offers outstanding reward-to-risk potential for those who are willing to consider the possibilities.

Individuals trade options for several reasons. Some trade to speculate on the expectation of a given price moment. Others use options to hedge an existing position. Still others use more advanced strategies in the hope of regularly generating extra income. All these are valid objectives and can be successful if they're done correctly.

How a Butterfly Spread Works

A butterfly spread represents a strategy that's unique to option trading. The most basic form involves buying one call option at a particular strike price while simultaneously selling two call options at a higher strike price and buying one other call option at an even higher strike price.

The process when using put options is to buy one put option at a particular strike price while simultaneously selling two put options at a lower strike price and buying one put option at an even lower strike price.

The net effect of this action is to create a "profit range," a range of prices within which the trade will experience a profit over time. A butterfly spread is most typically used as a "neutral" strategy. You can see the risk curves for a neutral at-the-money butterfly spread using options on First Solar (FSLR) in Figure 1.

The trade displayed in Figure 1 involves buying one 110 call, selling two 130 calls, and buying one 150 call. This trade has limited risk on both the upside and the downside. The risk is contained to the net amount paid to enter the trade: $580 in this example.

The trade also has limited profit potential with a maximum profit of $1,420 and this would only occur if FSLR closed exactly at $130 on the day of option expiration. It's unlikely but the more important point is that this trade will show some profit as long as FSLR remains between roughly 115 and 145 through the time of option expiration.

OTM Butterfly Spreads

The trade displayed in Figure 1 is referred to as a "neutral" butterfly spread because the price of the option sold is at the money. The option sold is close to the current price of the underlying stock. The trade can show a profit provided that the stock doesn't move too far in either direction.

An OTM butterfly is built the same way as a neutral butterfly: by buying one call, selling two calls at a higher strike price, and buying one more call option at a higher strike price. The critical difference is that the option that's sold isn't the at-the-money option with the OTM butterfly but rather an out-of-the-money option.

An OTM butterfly is a "directional" trade. The underlying stock must move in the anticipated direction for the trade to ultimately show a profit. The underlying stock must move higher for the trade to show a profit if an OTM butterfly is entered using an out-of-the-money call. The underlying stock must move lower for the trade to show a profit if an OTM butterfly is entered using an out-of-the-money put option.

Figure 2 displays the risk curves for an OTM call butterfly.

The trade displayed in Figure 2 involves buying one 135 call with FSLR that's trading at about $130, selling two 160 calls, and buying one 185 call. This trade has a maximum risk of $493 and a maximum profit potential of $2,007. The stock must be above the breakeven price of $140 a share at expiration for this trade to show a profit.

A look at the risk curves nonetheless indicates that an early profit of 100% or more may be available if the stock moves higher before expiration. The idea isn't necessarily to hold on until expiration and hope that something near the maximum potential is reached but rather to find a good profit-taking opportunity along the way.

When to Use an OTM Butterfly Spread

An OTM butterfly is best entered into when a trader expects that the underlying stock will move somewhat higher but doesn't have a specific forecast regarding the magnitude of the move. The trader would likely be better off buying a call option that would afford an unlimited profit potential if they anticipate that the stock is about to move sharply higher,

A trader is often better off establishing an OTM butterfly when implied option volatility is low. This trade costs money to enter so the implication of low implied volatility is that there is relatively less time premium built into the price of the options that are traded. The implied volatility is lower and the total cost of the trade is less.

Disadvantage of the OTM Butterfly Spread

The primary disadvantage of the OTM butterfly spread is that the trader must ultimately be correct about market direction. A loss will undoubtedly occur if they enter into an OTM call butterfly spread and the underlying security trades lower without moving to higher ground at any point before option expiration.

The Bottom Line

The OTM butterfly spread offers option traders at least three unique advantages.

First, it can almost always be entered at a cost that is far less than would be required to buy 100 shares of the underlying stock. Second, a trader can obtain an extremely favorable reward-to-risk ratio if they pay close attention to what they paid to enter the trade. Finally, a trader can enjoy a high probability of profit by having a relatively wide profit range between the upper and lower breakeven prices with a well-positioned OTM butterfly spread.

Not many trading strategies offer all three of these advantages.

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