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Short Butterfly Spread

How Does Short Butterfly Spread Work in Options Trading?

Short Butterfly Spread Risk Graph
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Short Butterfly Spread - Introduction

The Short Butterfly Spread is a credit spread volatile option strategy where you get to keep the net credit if the underlying stock rallies or ditches. As you can tell from the name itself, a Short Butterfly Spread is where you become the "Banker" in a Butterfly Spread transaction by selling a butterfly spread to someone who is speculating on the same underlying stock being stagnant.

You need to understand how a Butterfly Spread works before you can understand the dynamics behind the Short Butterfly Spread.

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

A Short Butterfly Spread is a complex volatile option strategy as the Short Butterfly Spread involves proper selection of strike prices and a trading account that allows the execution of credit spreads. As a complex volatile option strategy, the Short Butterfly Spread also has a narrower breakeven point than the basic volatile option strategies such as the Straddle and the Strangle and also puts time decay in your favor.

The Short Butterfly Spread belongs to the family of complex volatile option strategies, similar to the Short Condor Spread, Reverse Iron Butterfly Spread and Reverse Iron Condor Spread. Each of them has their own strengths and weaknesses but they all have one thing in common, and that is, they all have narrower breakeven points than the basic Straddle / Strangle and a lower maximum loss than a Straddle even though their maximum profit potential is limited. Here is a table explaining the differences:

Short Condor Spread Reverse Iron Condor Spread Short Butterfly Spread Reverse Iron Butterfly Spread
Debit/Credit Credit Debit Credit Debit
Max Profit Highest Higher High Low
Max Loss Low High Higher Highest
Cost of Position NIL High NIL Low
Breakeven Range Wide Widest Narrow Wider

As you can see from the table above, all of the above complex volatile option strategies comes with their own strengths and weaknesses. Option trading strategies are all about trade-offs. There are no single option trading strategy that has the best of all worlds.

Short Butterfly Spread - Classification

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

When To Use Short Butterfly Spread?

One should use a Short Butterfly Spread when one expects the price of the underlying asset to either rise or ditch greatly.

How To Use Short Butterfly Spread?

There are 3 option trades to establish for this strategy : 1. Sell To Open X number of In The Money Call Options. 2. Sell To Open X number of Out Of The Money Call Options. 3. Buy To Open 2X number of At The Money Call Options.

Veteran or experienced option traders would identify at this point that the short butterfly spread actually consists of a Bear Call Spread and a Bull Call Spread. This is similar to a Short Condor Spread except for the fact that the middle strike price has been combined into 1 same middle strike price.

The choice of which strike prices to write the short legs (trades 1 and 2 above) at depends on how volatile and how strongly the stock is expected to swing. The further away the two short legs are, the higher the maximum profit and the further the stock needs to move in one direction in order to reach breakeven.

Interestingly, the Short Butterfly Spread can also be executed by using Put Options instead of Call Options with the same effects. We will use Call Options as the standard example here.

Example : Assuming QQQQ trading at $43.57.

Sell To Open 1 contract of Jan $42 Call at $2.38
Sell To Open 1 contract of Jan $44 Call at $1.06
Buy To Open 2 contracts of Jan $43 Call at $1.63.

Net Credit = (($1.63 - $1.06) + ($1.63 - 2.38)) x 100 = $18.00 per position

Trading Level Required For Short Butterfly Spread

A Level 4 options trading account that allows the execution of credit spreads is needed for the Short Butterfly Spread. Read more about Options Account Trading Levels.

Profit Potential of Short Butterfly Spread :

Short Butterfly spreads achieve their maximum profit potential, which is the net credit received from putting on the positions, at expiration if the price of the underlying asset exceeds either the upper breakeven point or lower breakeven point. The profitability of a short butterfly spread can also be enhanced or better guaranteed by legging into the position properly.

Profit Calculation of Butterfly Spread:

Maximum Profit = Net Credit
Maximum Loss = (Difference between consecutive strike prices - credit) * 100

From the above example : Assuming QQQQ close at above upper breakeven point or below lower breakeven point.

Maximum Profit = $18.00 per position

Maximum Loss = ($1 - $0.18) x 100 = $82.00 per position if QQQQ closes at $43.57 upon expiration.

Risk / Reward of Butterfly Spread:

Upside Maximum Profit: Limited

Maximum Loss: Limited

Break Even Points of Short Butterfly Spread:

A Short Butterfly Spread is profitable if the underlying asset expires above the upper breakeven point or below the lower breakeven point.

1. Lower Breakeven Point : Net Credit + Lower Strike Price

Net Credit = $0.18 , Lower Strike Price = $42.00

Lower Breakeven Point = $0.18 + $42.00 = $42.18.


2. Upper Breakeven Point : Higher Strike Price - Net Credit

Net Credit = $0.18 , Higher Strike Price = $44.00

Higher Breakeven Point = $44.00 - $0.18 = $43.82.

Advantages Of Short Butterfly Spread:

:: Typically has a narrower breakeven range than a straddle or strangle.

:: Credit spread means that time decay works in your favor.

:: Maximum loss and profits are predictable.

:: Highest maximum profits amongst all the complex volatile option strategies.

Disadvantages Of Short Butterfly Spread:

:: Larger commissions involved than simpler strategies with lesser trades.

:: Not a strategy that traders with low trading levels can execute.

:: Margin is required as this is a credit spread.

Alternate Actions for Short Butterfly Spreads Before Expiration :

1. When it is obvious that the underlying stock is going to go up, you could buy back the short In The Money (ITM) call options to maximise profits, essentially transforming the position into a Bull Call Spread with an additional call option on it.

2. If the underlying asset has dropped in price and is expected to continue dropping, you could sell the long call options and hold the short call options. This action is only possible if your broker allows you to sell naked options.

3. If the underlying stock is going to go up and you want some downside protection in case the stock should suddenly drop, you could buy back the short Out Of The Money (OTM) call options, transforming the position into a Short Bull Ratio Spread.

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