Bear Butterfly Spread

Bear Butterfly Spread Risk Graph
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Bear Butterfly Spread - Introduction



The Bear Butterfly Spread is a complex bearish options strategy with limited profit and limited loss. It makes its maximum profit when the underlying stock drops to a pre-determined lower price. This makes the Bear Butterfly Spread ideal for price targeting.

Like a normal butterfly spread, the Bear Butterfly Spread can be constructed using only call options, known as the Bear Call Butterfly Spread, or only put options, known as the Bear Put Butterfly Spread.

The Bear Butterfly Spread is really just a normal butterfly spread using a lower middle strike price, effectively moving the maximum profit point down to a lower strike price.

The Bear Butterfly Spread also has the highest Return on Investment of all the complex bearish options trading strategies due to its extremely low capital requirement.

Find Options Strategies With Similar Risk Profiles Find Options Strategies With Similar Risk Profiles


Bear Butterfly Spread - Classification



Strategy : Bearish | Outlook : Moderately Bearish | Spread : Vertical Spread | Debit or Credit : Debit


Comparing The Bear Butterfly Spread


So, how does the Bear Butterfly Spread compare against the other two most popular complex bearish options strategies, the Bear Put Spread and the Bear Call Spread? Is the Bear Butterfly Spread worth the time and effort learning? We decided to compare the Maximum Profit, the Capital Outlay and the resultant Return on Investment to see if the Bear Butterfly Spread is worth using at all.

For this study, we expect the QQQ to reach the price of $56 by August expiration. As such, we shall aim for $56 on all three strategies using the minimum number of contracts. The results are tabulated below:

QQQ options chain on 24 April 2011. QQQ trading at $58.34.

May58Call = $1.11 , May57Call = $1.85 , May56Call = $2.69 , May55Call = $3.58
May58Put = $0.78 , May57Put = $0.52 , May56Put = $0.32 , May55Put = $0.21
Strategy Max Net Profit @ $56 Capital Outlay (Max Loss) ROI
Bear Butterfly Spread* $95 $5 1900%
Bear Put Spread $153 $47 325%
Bear Call Spread $154 $46** 334%

* : Bear Call Butterfly Spread was used
** : Maximum loss used as it is a credit spread


As you can see above, the Bear Butterfly Spread is an options trading strategy that rewards the precision of your prediction on the movement of the underlying stock. As long as the price of the underlying stock closes exactly on the predicted price, the Bear Butterfly Spread would produce a much higher Return on Investment (ROI). However, if the price of the underlying stock goes lower than the predicted price, the other two bearish options strategies would actually perform better.



When To Use Bear Butterfly Spread?


The Bear Butterfly Spread could be used when one expects the price of the underlying stock to move down to but not exceeding a certain strike price by options expiration.



How To Use Bear Butterfly Spread?


There are two ways to establish a Bear Butterfly Spread. One way is to use only call options. We call this a "Bear Call Butterfly Spread". The other way is to use only put options. We call that a "Bear Put Butterfly Spread". Either way uses the same strike prices and typically cost almost the same capital outlay, returning almost the same profit.

The composition of both kinds of Bear Butterfly Spread is the same. It involves selling to open 2 contracts at the strike price which you think the underlying stock will close at by expiraiton and then buying to open 1 contract one strike lower and another contract one strike higher.

Buy 1 Lower Strike + Sell 2 @ Expected Strike + Buy 1 Higher Strike





Establishing Bear Call Butterfly Spread


Veteran or experienced option traders would identify the Bear Call Butterfly Spread as consisting of an ITM Bear Call Spread and an ITM Bull Call Spread.

The choice of middle strike price is simply the price which you expect the underlying stock to close at by expiration of the position. The more accurate your prediction is, the greater the chance of hitting maximum profit.

Bear Call Butterfly Spread Example
Using the data from the comparison example above

Buy To Open 1 contract of May $57 Call at $1.85
Sell To Open 2 contracts of May $56 Call at $2.69
Buy To Open 1 contract of May $55 Call at $3.58

Net Debit = ($1.85 - $2.69 - $2.69 + $3.58) x 100 = $5.00 per position


In the above Call Bear Butterfly Spread example, we are expecting the QQQ to reach $56 on May expiration.



Establishing Bear Put Butterfly Spread


Establishing a Bear Put Butterfly Spread is exactly the same as establishing a Bear Call Butterfly Spread except that put options are used instead. Strike prices used are exactly the same. The resultant net debit and maximum of a Bear Put Butterfly Spread is theoretically the same as you would use call options, however, in practical options trading, sometimes Call options and Put options do not cost the same to put on. In stocks that are likely to be more bullish, its call options will be more expensive than its put options and vice versa. Therefore, an options trader needs to calculate whether a Bear Call Butterfly Spread or a Bear Put Butterfly Spread makes more sense in the prevailing circumstances.

A Bear Put Butterfly Spread actually consists of an OTM Bear Put Spread and an OTM Bear Call Spread placed around a central strike price ($56 in this case).

Bear Put Butterfly Spread Example
Using the data from the comparison example above

Buy To Open 1 contract of May $57 Put at $0.52
Sell To Open 2 contracts of May $56 Put at $0.32
Buy To Open 1 contract of May $55 Put at $0.21

Net Debit = ($0.52 - $0.32 - $0.32 + $0.21) x 100 = $9.00 per position


In this case, Bear Put Butterfly Spread requires a slightly higher net debit than the Bear Call Butterfly Spread, so the Bear Call Butterfly Spread should be used instead.



Choosing Strike Price and Expiration Month for Bear Butterfly Spread


The choice of middle strike price for Bear Butterfly Spread is the price to which you expect the stock to end up by expiration. The two long legs would then be put on one strike higher and one strike lower than the middle strike.

The choice of expiration month for Bear Butterfly Spread is typically when you expect the stock to hit the expected strike price. Such targetting is possible when the stock is expected to hit a certain price on a certain day due to events such as a buyout. Bear in mind that Bear Butterfly Spreads are adversely affected by implied volatility the longer the expiration. More on the greeks of Bear Butterfly Spreads below.



Trading Level Required For Bear Butterfly Spread


A Level 3 options trading account that allows the execution of debit spreads is needed for the Bear Butterfly Spread. Read more about Options Account Trading Levels.



Profit Potential of Bear Butterfly Spread


Bear Butterfly Spreads achieve their maximum profit potential when the underlying stock closes exactly on the middle strike price by expiration. The profitability of a Bear Butterfly Spread can also be enhanced or better guaranteed by legging into the position properly.



Profit Calculation of Bear Butterfly Spread


Maximum Profit = Strike Difference between Long and Short Leg - debit
Maximum Loss = Net Debit

From the above Bear Call Butterfly Spread example :

Maximum Profit = [($57 - $56) - 0.05] x 100 = $95
Maximum Loss = $5

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Risk / Reward of Bear Butterfly Spread



Upside Maximum Profit: Limited

Maximum Loss: Limited



Break Even Points of Bear Butterfly Spread:


A Bear Butterfly Spread is profitable if the price of the underlying stock remains between the higher and lower breakeven point.

1. Lower Breakeven Point : Lower Strike Price + Debit

From the above Bear Call Butterfly Spread example :

Debit = $0.05, Lower Strike Price = $55.00

Lower Breakeven Point = $55 + $0.05 = $55.05.

And

2. Upper Breakeven Point : Higher Strike Price - Debit

From the above Bear Call Butterfly Spread example :

Debit = $0.05 , Upper Strike Price = $57.00

Higher Breakeven Point = $57.00 - $0.05 = $56.95.


In this case, our Bear Call Butterfly Spread makes a maximum profit of $95 if the QQQ closes exactly at $56 during May Expiration and remains profitable if the QQQ closes within the price range of $55.05 to $56.95.



Bear Butterfly Spread Greeks



Delta: Negative
Bear Butterfly Spreads have a slightly negative delta which allows the position to profit as the price of the underlying stock goes down. This is characteristic of all bearish options strategies.

Gamma: Positive
Being slightly Gamma Positive, the delta of a Bear Butterfly Spread will becoming increasingly negative as the price of the underlying stock goes down, increasing its profitability downwards.

Vega: Variable
Vega for Bear Butterfly Spreads tend to be neutral or slightly positive with nearer expiration but slightly negative for longer expiration. As such, Bear Butterfly Spreads placed with longer expiration tends to be negatively affected with increases in implied volatility.

Theta: Neutral
Bear Butterfly Spreads are not significantly affected by Time Decay as the erosion of extrinsic value on the long legs are offset by the erosion of extrinsic value on the short leg.



Advantages Of Bear Butterfly Spread



:: Highest ROI of the complex bearish options trading strategies.

:: Able to aim maximum profit point at any specific price you want.

:: Low capital requirement results in the lowest maximum loss of all complex bearish options strategies.



Disadvantages Of Bear Butterfly Spread:



:: Larger commissions involved than the other bearish option strategies with lesser trades.

:: Needs to be extremely accurate on the price which the underlying stock will end up by expiration.



Adjustments for Bear Butterfly Spreads Before Expiration :



1. When it is obvious that the underlying stock is going to go down beyond the middle and lower strike and you are holding a Bear Put Butterfly Spread, you could close out the middle strike short puts and hold on to the long puts for unlimited downside profit. If you are holding a Bear Call Butterfly Spread, you could close out the two long legs and hold the short legs to expiration in order to profit from the whole extrinsic value of the short legs. This will turn the position into a naked call write which will require Margin.


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