One of my favorite ways to trade is using butterflies. A butterfly is an options strategy that is constructed using a bull and bear spread. The reason why I love using butterflies is because they’re a very flexible way of setting up a trade that could potentially make you money in many scenarios. When you trade a stock or buy options you can only make money when one condition happens: the underlying has to move up (or down in the case of buying a put option). To make matters worse, when you buy options, if the underlying doesn’t move fast enough you will end up losing the entire premium paid by expiration. Butterflies allow you to setup trades to express bullish, bearish, or neutral opinions and profit if any of these, or multiple scenarios play out. Let us look at some examples:
Neutral butterfly
A neutral butterfly or balanced butterfly is made up of a bear spread and a bull spread where the strikes of the wings (long options) are at the same distance from the mid short strike. In this example, we see a 60 point wide 16 DTE (days to expiration) call butterfly on SPX. This structure is accomplished with a bull spread (Buy 1 $4400 Call and Sell 1 $4460 Call) and a bear spread (Sell 1 $4460 Call and Buy 1 $4520 Call). The green triangle line represents the value of the butterfly at expiration. As you can see, this butterfly can be bought for $750 and the max possible profit is $5,250. Keep in mind that this max profit can only happen at the expiration date if the price of SPX closes exactly at the short strike ($4460 in this case). The curved lighter green line is the T+0 line which represents the potential pay-off as of today.
Let’s look at how this structure would play out over time by adding more T+x lines:
As time passes, each contract leg of the butterfly loses value at a different rate. Together this makes the butterfly become more valuable as a whole as we get closer to expiration.
Broken wing butterflies
Looking at the example above you might ask, “but Gabe, this is not really balanced, you have negative delta. The T+0 line is slanted”. This is due to the skew of the options at the time of this writing. The good news is that the delta could be adjusted by converting the structure into a broken wing butterfly. We can accomplish this by bringing the upper wing closer
down towards the mid strike. The downside is that the max risk on the trade increases if we just adjust one side. The further upside is that we can control the risk by adjusting both wings. In other words, by moving the wings up or down we can control the delta and the risk on the trade. Let’s look at another example below. In this case, we are bringing the upper wing down from 4520 to the 4510 strike.
What if we wanted to neutralize delta but keep the same amount of risk in the trade? We can accomplish this by bringing the lower wing up a strike to 4415 and bringing down the upper wing to 4500. The result is a max loss of $714 instead of $1,285 which is similar to the first example. Delta in this case is not exactly zero but it’s close enough for illustration purposes.
How much money can I make?
If you’ve never traded butterflies you can look at the risk profile and think that you can make a 500% return on your money. I mean all you have to do is predict the price by expiration, easy right? Wrong. You can expect to make some decent returns but I would strongly suggest that you try a few of these and observe how they behave in different volatility environments and with different expiration dates. The longer the expiration date the less gamma risk you will be exposed to, think of it as how volatile your PnL is. Be aware that in this case you will also get a slower theta decay which means that it will take longer to make money. I personally trade all kinds of butterflies in many different expirations but you have to find what you’re comfortable with and what your risk tolerance is. If you hold a butterfly to expiration gamma exposure will cause you your PnL to move up and down like a pinball’s score display. If you like that kind of action then go for it. You can trade 0DTE to 1700DTE butterflies. The sky is the limit. Feel free to ask questions or send me some feedback on this post.
On the next post I will talk about directional butterflies. Stay tuned!
Gabriel Saientz 