How to Create a Butterfly Spread

The stock market has shown much volatility in the past three months, with the major market indices reaching new highs and then falling back down. The reason for this bullishness has been an improvement in economic data and much stronger earnings in the third quarter. However, expectations have become so high that it has been difficult for stocks to reach new highs despite the positive news. In fact, there is a wide range of forecasts for the stock market, with analysts expecting everything from the Dow ($INDU) to reach 11,000 - to a severe drop for the indices. However, another possibility is that the major market indices will consolidate some after such a huge run up in price this year. Thus, we have decided to look at a neutral trading strategy called a butterfly.

A butterfly is a strategy that combines two spreads to make one trade. It can consist either of all puts or all calls, but includes a bull spread and a bear spread that share a common strike price. For example, an ATM call butterfly would consist of the following if XYZ stock were at 50:

• Buy 1 45 Call (Wing)
• Sell 2 50 Calls (Body)
• Buy 1 55 Call (Wing)

A butterfly spread will create a debit to enter, which is also the max risk. The same risk profile would be created using a put butterfly, just that the calls would be replaced with puts. A butterfly spread has the following characteristics:

• Max Risk: Debit
• Max Profit: Difference in strike prices, less the debit paid. Max profit is achieved if the stock closes at the middle strike price at expiration.
• Lower Breakeven: Lowest strike plus debit
• Upper Breakeven: Higher strike minus debit

Below is a generic risk graph of a butterfly trade. The risk graph would look the same regardless of whether we use calls or puts.

One thing this risk graph doesn’t show us is how a butterfly trade profits before expiration. Unfortunately, there is little profit before the last 30 days of the trade, so we normally want to use options that are front month. We would prefer to use options that are showing high implied volatility, but this isn’t our first priority.

Our first priority is to find a security that we feel will trade in a range until expiration. For example, we might feel that the Nasdaq 100 Trust (QQQ) is going to trade sideways for the next month, so we could look at using a butterfly on this security. In fact, let’s use this as our mock trade this month. Figure 2 shows a chart of the Qs.

As of the close of trading on October 29, the Qs were priced at 35.32. However, we feel that the Qs might fall a bit from this price by November expiration. This is because they are approaching resistance and this should push the security lower. This being the case, we are going to enter a mock trade using the 31, 34 and 37 puts. We are using the puts because they are offering just a slightly better entry price at the moment. Thus, here is our trade:

• Buy 1 Nov 31 Put @ 0.10
• Sell 2 Nov 34 Put @ 0.35
• Buy 1 Nov 37 Put @ 1.90
• Entry Debit = $130
• Max Profit = $170
• Downside Breakeven = 32.30
• Upside Breakeven = 35.70

Normally, a butterfly trade is delta neutral. This means that the delta of each option added up would be close to zero. However, this only occurs when we use ATM options for the body of the butterfly. In our case, we are entering a slightly bearish trade, looking for the Qs to fall closer to 34 by November expiration. Therefore, the total delta currently for this trade is -31. However, gamma currently sits at nearly -10, so a point move in the underlying will push delta closer to zero. Once the Qs trade near 34, delta will be very close to zero. Figure 3 shows the risk graph of this mock trade.

Notice how the profit jumps sharply once the trade reaches expiration. If we were using a butterfly that was several months out, the coloured lines would be even closer to zero than the current graph. This is why we choose to use front month options when trading butterflies.

We’ll update this trade as the week’s pass leading up to November option expiration.

Jody Osborne