The Magic of Butterflies - Part 14

Welcome to Part 14 of my series of articles on the Butterfly. In last week’s article we began analyzing the results of our Put Butterfly search on the SPY (exchange traded fund of the S&P 500). We discovered that the cheaper the trade was, the more profit potential it had, and the more expensive the trade was, the less profit it could make.

This may already sound like a no-brainer: Let’s make all our trades as cheap as possible, as the cheaper they are, the more profit they can make. Sound too good to be true? Of course, it is. There is a third element to consider here in construction and placement of our trade (and of any strategy actually), and that’s probability.

The factors that make Butterflies cheaper are shorter term options, narrower strike widths, and placement further OTM (Out of the Money). Let’s go through these terms together. All else being equal, a 30 day Butterfly is going to be cheaper than a 60 day Butterfly. The trade is cheaper, but you have less time to be right.

The narrower you make the strike widths, the cheaper the trade becomes to buy and the more profit you can make, theoretically, but the probability of making this ‘max profit’ is much lower because you have a much narrower range to make it in. This can become like trying to hit a bull’s eye when trading narrow Butterflies. The difficult thing with this as well, is that this ‘max profit’ only occurs if the stock finishes right at the strike price of the short (sold) options, on expiration day. What is the probability of hitting that?

The other factor is placement. The further OTM you place the Butterfly, the cheaper it is. Let’s take a Call Butterfly as an example. As you scroll down an options chain, going further and further OTM on the Calls side, the prices get cheaper and cheaper. As Call options get cheaper the further OTM you go, strategies constructed with Calls also get cheaper, whether they be Butterflies, Bull Call Spreads or even Calendar Spreads. The simple reason why options are priced cheaper the further they go OTM, is because they have less probability of expiring In The Money. The same goes for Butterflies, the further OTM they are, the less probability they have of becoming profitable trades, because the stock has to move further to get to the mouth area, compared with an ATM fly, where the stock is already there.

Combine all these factors together, a Butterfly placed short term, far out of the money and with narrow strikes, and you will see a trade with a very little entry cost and a super high reward. But now you should be starting to see that this sort of a trade would carry an extremely low probability of becoming profitable.

So what would be a way of constructing such a trade, making the Butterfly a trade with a greater probability of making some money? We could construct it with wider strikes, and ‘At’ or ‘Closer to’ The Money. However I would still consider keeping the fly short term, as in 30-40 days long, because the Butterfly doesn’t really start to work its magic until it reaches those last 30 days!

Matt Baker