Butterfly Options Strategy

2022-05-09 | Danielle Shay

The butterfly options strategy is a classic favorite at Simpler Trading. The ability to establish multiple strike targets streamlines the risk-to-reward process. But, what is a butterfly strategy? To break it down, a butterfly is a neutral, multi-leg setup that combines bullish and bearish spreads.

The butterfly options strategy can be used in all markets. Traders who can identify bearish or bullish trends will have an advantage in finding the perfect setups. Let’s get into detail about how traders such as yourself can learn this new strategy, so you can apply it in the market.

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Butterfly Options Video Guide

Butterfly Multi-Strike Advantage

Butterflies are a trader-favorite strategy because of their relatively low cost. Typically, a butterfly trade can cost less than half of what a long call would cost when trading the same stock. Since the underlying components of the setups for the butterfly strategies are the same, traders already have them in their trading toolbox. For experienced traders, this strategy is not complicated to master. Both puts and calls can be used to place a butterfly spread.

Traders get paid when they sell a put or call but pay a premium when they buy a put or call. To get a more risk-defined trade, traders can sell a put and buy a put at a lower strike to create a put vertical spread. Similarly, traders can sell a call and buy a call together to create a call vertical spread. To get a butterfly, you’re just combining two vertical spreads. The profit potential and the performance of the spread in directional markets vary. The image below shows how to buy a call butterfly. To create a long call butterfly, you buy 1 contract of the lower strike call, sell 2 contracts of the middle strike call, and buy 1 contract of the higher strike call. 

For maximum profit, you are looking for the stock to be near the middle strike close to the expiration date of the trade. Butterfly prices fluctuate wildly while you’re in the trade because there are 3 legs to the trade. But when you buy a butterfly, your maximum loss is what you paid for the trade. Butterfly options trades gain most of their value the closer to expiration you get. So when you’re trading butterflies, you want to project price and timing to determine what strike prices and what expiration date you choose.

The image below shows how to buy a put butterfly. To create a put butterfly, you buy 1 contract of the lower strike put, sell 2 contracts of the middle strike put, and buy 1 contract of the higher strike put. The maximum you can lose is how much you pay for the trade. Your max profit occurs if the stock price is at the center strike price put near expiration. Your max profit on butterfly options will depend on how wide the strike prices are.

Various Butterfly Options Strategy

Traders often begin with a simple butterfly, then add more strategies as trading opportunities present themselves. The goal for traders is to get new strategies “under their wings” after they master the simple butterfly options spread.

These are just some terms and characteristics. Below are what butterfly traders may see:

  • Butterfly Options Strategy  – Simple Butterfly Options spreads use three different option strike prices, all within the same expiration date, and can be created using calls or puts. A typical butterfly would be constructed as follows: Traders buy one in-the-money call, sell two at-the-money calls, and buy one out-of-the-money call. The upper and lower strike prices are equal distances from the middle, or at-the-money, strike price. A butterfly spread options strategy uses four options contracts with the same expiration but three different strike prices to create a range where the method can profit.
  • Iron Butterfly Options Strategy – The Iron Butterfly spread is best suited for lower volatility markets. This spread consists of four stock options trades instead of three. This setup is created by buying an out-of-the-money put option with a lower strike price, writing an at-the-money put option, writing an at-the-money call option, and buying an out-of-the-money call option with a higher strike price. The maximum profit occurs if the underlying price stays at the middle strike price.
  • Reverse Iron Butterfly Options Strategy – This advanced spread is created by writing an out-of-the-money put at a lower strike price, buying an at-the-money put, buying an at-the-money call, and writing an out-of-the-money call at a higher strike price. This trade is better suited for high-volatility markets. Maximum profit occurs when the underlying price moves above or below the upper or lower strike prices.
  • Broken Wing Butterfly Options Strategy – This is an advanced spread with risk inclined to one side. This spread transfers all the risk in one direction rather than equal risk covering price movement in either direction. This setup is higher risk for maximum loss should the price direction change. Traders are rewarded with a higher profit when the stock goes in the projected direction.
  • Long Call Butterfly Options Strategy – This spread is created when traders buy one in-the-money call option with a low strike price, write two at-the-money call options, and buy one out-of-the-money call option with a higher strike price. The maximum profit is made if the underlying price at expiration is the same as the written calls. The max profit equals the written option’s strike, less the lower call’s strike and the premiums and fees.
  • Long Put Butterfly Options Strategy – This advanced spread buys one put with a lower strike price, sells two at-the-money puts, and buys a put with a higher strike price. Like the long call butterfly, this position has a maximum profit when the underlying price stays at the strike price of the middle options. The maximum profit equals to the higher strike price minus the strike of the sold put less the premium and fees. The maximum loss is limited to the initial premiums and fees.
  • Double Iron Butterfly Options Strategy – This advanced credit neutral (market) options strategy is the combination of two Iron Butterfly spreads. Iron Butterfly spreads maximum target profitability around a single price point with a favorable risk-to-reward ratio and higher potential gain. When two Iron Butterfly Spreads are put together, a Double Iron Butterfly Spread is formed. The Iron Butterfly Spread’s maximum profit range allows spread traders to target two different profit price points.

These may sound complex, but It’s essential that traders first master the basic butterfly strategy that underlies the multi-leg options strategy.

Can traders make money using butterflies?

The market never offers up a sure thing to any trader – whether they have been trading for five months or five years. Limiting risk is an essential strategy that all traders can take. Self-discipline is an essential characteristic of successful trading. That means following the rules of a setup, adhering to your trading discipline, and not taking more risk than your trading account can handle. Fortunately, the risk-to-reward ratios are the core structure of butterfly spreads.

As a trader, there is only one thing that can be controlled in any trade: the amount of risk each trader is willing to take. Some trades look better than others, and it can be easy to say, “This trade looks to be a high probability. Therefore I’m taking a higher risk to gain a higher reward.” Remember, when more money is to be made from a trade, more money can be lost.

Trades are, in essence, a counterpunch to the stock price action and the broader market environment. Within the bullish and bearish spreads setup, the butterfly spread strategy establishes the ability to calculate and maintain control of the risks versus the rewards. The ability to calculate what you are willing to lose if you are wrong raises the other question of how often you have to be right to be profitable?

When you trade a long call, suppose you are wrong three times in a row, and you risk three to make one. It’s challenging to get ahead in that type of risk-to-reward parameter. With a butterfly spread, it’s the opposite. When using a butterfly strategy, traders typically risk one to make four (1:4 ratio) as they look to have returns of 50%, 100%, or even 150% of that. A perfect strike won’t happen every single time. Fortunately, maximum returns aren’t necessary for traders to grow a trading account.

Having a good percentage of successful returns is the goal of trading with butterfly spreads. This becomes more likely when stocks are trading within a range. Fortunately, this tends to be the case and the scenario is visible on the charts. Stocks almost always trade-in ranges. Traders need to quantify the range and the time frame.

Growing small account strategies

As traders begin trading, they often have limited trading funds and need strategies that can grow a small account over time. Using butterfly spreads allows traders who want to grow trading accounts (of any size) to capitalize on stock price movement with controlled risk. 

Traders with small accounts generally don’t have the ability to trade expensive tickers such as Amazon, Google, or Tesla. A typical long call on these tickers can cost thousands of dollars. Traders can use the butterfly options spread to enter a trade for very little cash. During a volatile market, expensive trades in either direction can be complicated with the added risk. These strategies allow traders to find a way to trade at reasonable prices and still have good risk-to-reward even in a directional trade. A butterfly spread is an excellent strategy for traders who enjoy trading during consolidation, breakouts, and trending charts.

Simpler traders significantly value these setups ability to convert trading setups using a risk-focused strategy that helps grow trading accounts. Trading butterflies offers a controlled risk-to-reward setup and a higher return probability than a comparable long trade. As traders consider the characteristics of a butterfly spread naturally, introduce setup requirements that help traders reduce trading risk. This is an excellent time to add these strategies to your trading footprint.

Sign Up for the Stacked Profits Mastery

The Butterfly strategy can be a great method to learn and apply in the market. But if you are still needing a mentor to help you better understand the different type of butterfly strategies, then consider signing up for Danielle Shay’s Stacked Profits Mastery Program. Join today and gain immediate access to monthly live trading sessions, follow Danielle’s trades in real-time, and follow along with her trade spreadsheet. Why trade alone when you can trade with us, only at Simpler Trading.

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FAQs on Butterfly Options Strategy

Q: How do I establish strike prices for a butterfly spread?

A: The entry price is a critical element of a butterfly setup. Danielle uses directional setups to trade butterflies which is her favorite strategy for growing small accounts. When she has a directional setup with a pullback that has settled into consolidation, she identifies Fibonacci areas of support. From there, she places butterflies, setting it up so that a breakout from the setup level to the price target is where she’d find her ‘Stacked Profits Zone.’ 

These areas of support allow you to identify a time frame and strike price targets. She likes to do this with a 1:4 risk-reward ratio on the trade. As far as growing a small account, you want to focus on trades where you can get from 25-100% wins on the debit you paid. 

Q:  How do I establish price points for a butterfly spread?

A: Traders use technical analysis to determine the strike price and expiration date. Butterfly traders watch the charts for signals of a breakout. 

Directional traders love trading consolidation, breakouts, and trending charts. A butterfly is a great strategy to utilize with these chart elements. To find a directional setup, you need to have a reason you think the stock will move. Then you can identify critical support and resistance levels, your trading timeframe, and select your strikes using your options chains.

Q: What are the best times I should use a butterfly spread?

A: Butterfly spreads are most effective when volatility is low and the market is neutral. The Butterfly Spread Options strategy works best in a non-directional market or when you don’t anticipate the stock price to be very volatile.

Traders rarely place butterfly trades during the same week of earnings. You don’t want to put butterfly setups in a rising volatility environment. The short strikes can work against you. You don’t want to place a butterfly when your price is too close to the set target price or too close to the price that the stock is currently trading.

Q: What to consider before buying options?

A: Before you buy options, make sure you understand how they work, have a brokerage account, make a trading plan. You can also consider paper trading as a practice.

Q: What is an iron condor spread?

A: Selling an iron condor spread means selling a call credit spread and put credit spread at the same time on a stock. You want the stock to trade between the options contracts you sell for maximum profit on the trade.

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