General Introduction

When executing a Butterfly Spread, note that this strategy combines both a bull and a bear spread and has a limited potential for profit and loss. The trade will always consist of four options contracts with the same expiration date and three different strike prices. Combining the options in various ways will create different types of butterfly spreads, each designed to either profit from volatility or low volatility.

Please note that contracts with a higher and lower strike prices (wings) will always be the same distance from the target price contracts (body).

Long Put Butterfly

Disposition: Bearish + Time Decay

How it Works

A long put butterfly spread is a three-part strategy that is created by buying one put at a higher strike price, selling two puts with a lower strike price and buying one put with an even lower strike price. All contracts have the same expiration date and the purchased puts will always have the same distance from the sold contracts. Notice that there are 3 strike prices and 4 options contracts.

Let’s say AMZN is $120 and we expect the price to fall below $115 but not lower than $110. A possible trade could look like below.

BTO 1 AMZN 15JUL MTHLY 115.00 PUTS

STO 1 AMZN 15JUL MTHLY 110.00 PUTS

STO 1 AMZN 15JUL MTHLY 110.00 PUTS

BTO 1 AMZN 15JUL MTHLY 105.00 PUTS

Max Profit & Max Loss

When entering this trade the max profit and loss one can accrue will be limited. Our goal is to profit from our original hypothesis of AMZN falling below $115 and as the price nears $110, selling our position. The closer the price is to $110, the more of the max profit we will keep per contract at expiration.

We calculate max profit by taking the difference between the highest strike price and subtracting the middle strike price. In this case 115 - 110 = 5. Let’s say opening the trade cost 1.50. Our total max profit would then be 3.50 per contract before commissions.

On the other hand, max loss will come into play if the security price is above the higher strike price or below the lower strike price at expiration. We can calculate this value by taking the net cost paid for the trade + commissions. In this case, our max loss would be $1.50 per contract + commissions.

Risk Management & Strategy

1. Position size: 3 - 5% of your total account value

2. Be ok with not being able to take every trade that does not make sense

3. If entering more than 1 contract, exiting a portion of the position as the trade develops (in this case with time getting closer to exp) is a great way to reduce loss and secure profit.

4. Have a predetermined set amount you are willing to lose and gain (OCO order is a great way to take emotion out of trading)

5. Practice executing this trade in a simulator prior to attempting in live account

Pro tip: knowing where there could be support and resistance will help set realistic profit and loss goals.

Disposition: Bullish + Time Decay

How it Works

A short put butterfly spread is a three-part strategy that is created by selling the wings and buying the body. In other words,

let’s say AMZN is $120 and we expect the price to increase above $125 but not above $130.

Like its counterpart the “long put butterfly,” this too is a three-part strategy but will differ in that we will sell the lower and the higher strikes as our wings and buy the middle strikes as our body. When entering this type of trade, you will receive a credit. The more time that passes while in the trade, the more of the credit you will be able to keep when closing the position.

A possible trade could look like below.

STO 1 AMZN 15JUL MTHLY 125.00 PUTS

BTO 1 AMZN 15JUL MTHLY 130.00 PUTS

BTO 1 AMZN 15JUL MTHLY 130.00 PUTS

STO 1 AMZN 15JUL MTHLY 135.00 PUTS

All contracts have the same expiration date and the purchased puts will always have the same distance from the sold contracts. Notice that there are 3 strike prices and 4 options contracts.

Max Profit & Max Loss

When entering this trade the max profit and max loss one can accrue will be limited. Our goal is to profit from our original hypothesis of AMZN rising above $125 but not $130 and staying within that range for as long as possible.

We calculate max profit by taking the credit we received when opening the position minus the cost of exiting the position. In this case, if we received .40 credit per contract and sold a few weeks later, exciting the position for a cost of .20 per contract, we would end up with .20 cent profit (.40 - .20).

On the other hand, max loss will come into play if the security price is above the higher strike price or below the lower strike price at expiration. We can calculate this value by taking the strike price of the purchased put / body (130) minus the strike price of the lower strike (125) minus the credit received .40 per contract. The max loss would then be 4.60 per contract + commissions.

Risk Management & Strategy

Pro tip: knowing where there could be support and resistance will help set realistic profit and loss goals.