Directional butterflies

In the last post I explained some of the basics of the butterfly trade. I covered adjusting deltas and how to stay neutral while making money no matter which direction the market moves. Today we’ll look at directional bullish and bearish butterflies.

Balanced butterflies

Let’s say that I have a bullish view of SPX for the next few weeks. That means that I think SPX will go up in price. There’s many ways to play this and a bullish butterfly is one way to go about it. The risk profile can look like something like this:

Balanced OTM bullish butterfly 50 points wide
Balanced OTM bullish butterfly 50 points wide

If you have a specific target in mind, let’s say you think SPX will end the week at around 4200, you can do an Out of The Money balanced butterfly with the short strikes at 4200. You can use the wings to control your buying power and delta exposure. The width of the butterfly dictates the the probability of profit, the deltas and the profit zone at expiration. So it’s a give and take game. Here are a few examples of different widths so you can see how the risk profiles vary.

Butterfly Examples

When your wings are closer to the center strike, the body of the butterfly gets thinner so this means that the profit zone is smaller at expiration. Conversely, as displayed below, you can see that this version is almost 4 times cheaper.

Balanced OTM bullish butterfly 25 points wide
Balanced OTM bullish butterfly 25 points wide

Let’s look at what happens when we widen the wings:

Balanced OTM bullish butterfly 100 points wide
Balanced OTM bullish butterfly 100 points wide

We can see in the example above that while widening the wings provides a larger profit zone with increased theta, it also increases risk / cost.

Directional Broken wing butterflies

With the OTM balanced butterflies you have a price point at which delta starts working against you. In other words, if price goes up “too much” you will start to lose money. If you have a bullish view but you don’t have a specific target in mind (i.e.: you think the underlying will be above a certain level) you can express this view with a broken wing butterfly.

25x50 Broken Wing Call Butterfly
25×50 Broken Wing Call Butterfly

By bringing the upper wing close to your short strike you can eliminate the risk on one side of the butterfly. This would be similar to the risk profile for a credit spread but with the added max profit bonus at the short strike level of the butterfly.

In conclusion, butterflies are a very versatile tool to have in your arsenal. You can play around with the wings and strikes to get the risk reward you prefer and are comfortable with.

In the next post I’ll be talking adjustments. Make sure you subscribe to get notified about new posts.

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