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
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.
|Short Condor Spread
|Reverse Iron Condor Spread
|Short Butterfly Spread
|Reverse Iron Butterfly Spread
|Cost of Position
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.
One should use a Short Butterfly Spread when one expects the price of the underlying asset to either rise or ditch greatly.
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.
Example : Assuming QQQQ trading at $43.57.
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
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.
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.
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 Loss = ($1 - $0.18) x 100 = $82.00 per position if QQQQ closes at $43.57 upon expiration.
Upside Maximum Profit: Limited
Maximum Loss: Limited
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.
:: 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.
:: 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.
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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