Butterfly Spreads
Butterfly spreads are the most popular combination spread. They are usually played on indices.
Consists of a debit (Bull Call)and a credit spread (Bear Call) on the same stock. (index)
Has the best chance of making a maximum profit if the stock (or index) is flat.
If playing the indices, use calls because calls on indices provide more time value than puts.
Butterfly spreads perform best in NEUTRAL markets.
One of the three positions on a butterfly spread is naked so always enter the long side first if you leg into a trade. You can then enter the short side without needing naked option approval. The long sides will cover the short side if your contract is assigned unexpectedly.
Butterfly spread:
(We will use an index)
1. Buy a call on a flat trending index that is higher than the identified resistance level.
2. Buy another call on the same flat trending index. This call should be the same distance away from the index price that the first call was bought. For example if the first call was bought 100 points above the index, the second one should be bought 100 points below the current value of the index.
These first two steps are called The Wings
3. Sell two calls on the same flat trending index At The Money. This is the body.
Butterfly spreads are debit spreads. You calculate the net debit by adding the total premium received from selling the calls to the total cost of buying the ITM and OTM calls.
We will use a fictitious index call MWX (mrweekend Index)
MRX= 1000.00
Support is 980.00
Resistance is 1020.00
Buy the 1020.00 call for –7.00
Buy the 980.00 call for –18.00
Sell (2) 1000.00 calls for +24.00
Net Debit= -1.00
Max Profit= If MRX closes at 1000.00
Max Profit= The difference between the spread between the ITM strike price and the ATM Strike price minus the net debit. In this case it is 19.00. (1020-1000-1=19)
Max Loss = Net Debit=1.00
Assume MWX drops to 975.00
1020 call expires worthless=0.00
Both 1000 calls expire worthless=0.00
980 call expires worthless=0.00
Max loss=-1.00
Exiting Early:
Exit if a profit target has been reached.
MRX drops to 990.00 on day 21 and is within two weeks till expiration, the premiums for all of the call options will have changed. If the difference between the three positions is larger than the net debit, close the trade for a profit.
Net Debit = -1.00
Hold the 1020 call
Buy back both 1,000 calls for 5.00 each (5x2=-10.00)
Sell the 980.00 call for 15.00
Net profit=+4.00 (-1.00 –10.00 +15.00=+4.00)
Current Index is 1320.00
Buy the 1340 call for -790
Buy the 1,290 call for -41.80
Sell the two 1315.00 calls for +41.40
Net Debit= -8.30
Max gain would be at 1315.00
Lets say SPX closes at 1315 on exp date
The spread is 25.00
Spread-Net Debit-Net Profit
25-8.30=+16.70
Assume the stock is at 1,360 on exp date= max loss
Since the index closed above all 3 strike prices each option will be exercised and the spread will be exercised and it will assume max loss
1340 is exercised for +10.00
Both Oct 1350 calls are exercised for -70.00
35.00 x 2=70
The 1290 call is exercised for +60.00
+10 -70 +60 -8.30= -8.30
The same thing will happen if the index drops to 1280
All the calls expire worthless and we assume max loss
Assume the index closes at 1300 on exp date
the 1340 call expires worthless=0.00
Both 1315 calls expire worthless=0.00
The 1,290 call is sold for 10.00
net profit = 1.70
10.00- 8.30=1.70
Assume the index is 1,320 at expiration
1,340 call expires worthless=0.00
Both 1315 calls are bought back for -10.00
The 1290 call is sold for +30.00
Net profit=+11.70
-8.30 - 10.00 + 30.00=11.70
