Five advanced options trading strategies using the butterfly

5 advanced options trading strategies using the butterfly

The butterfly in options trading is a strategy that limits risk and simultaneously limits profit. Traders combine the use of both call and put options when they trade butterflies, and they buy and sell options at three different strike prices. The goal is to profit from a specific price move in the underlying asset. Depending on whether the trader feels the market will be bullish or bearish, the specific butterfly strategy varies. The strategy gets its name from the profit-loss diagram, which has the shape of a butterfly.

In this article, we will explain when the butterfly strategy is perfect for and how it works. Then, we will explore 5 options trading strategies using the butterfly. Finally, we will examine different scenarios and market fluctuation directions so you can get the hang of how the strategy is used.

When should I use the butterfly?

Traders use different variations of the butterfly depending on whether the market is bullish or bearish. Generally, traders will implement the butterfly when they believe the underlying asset will move slightly in the market. As the focus is on limiting risk, traders normally only act when the market is relatively stable and there is low volatility.

How the strategy works

The butterfly strategy can be complex, and traders should have a good understanding of options trading and the underlying market before attempting to use it. Below is an overview of how it works:

Firstly, the trader will identify the underlying asset they want to trade. This can be a stock, commodity or index. They will then select an expiry date for the options contract.

Afterwards, they will buy both call and put at-the-money options, and these are options with strike prices that are equal to the asset’s current market price.

Simultaneously, they will sell both call and put out-of-the-money options. These are options with strike prices that are higher and lower than the asset’s current market price.

The trader waits out the period between the present moment and when the options expire, and they monitor the markets in this time. If the underlying asset does not manage to move much, the options will expire worthlessly, and the trader will earn a small profit from the difference in the premium collected from the options bought and sold.

However, if the market does move substantially, the trader will incur a loss when the options increase in value, beyond the price of the premiums.

5 options trading strategies using the butterfly

Below are 5 advanced options trading strategies that use the butterfly. Some of them are best fit for slightly bullish markets, and the others slightly bearish.

Long Butterfly Spread with Calls                                   

The first strategy is the long butterfly spread, using call options. This combination requires the trader to buy a call at Strike Price A, sell two calls at Strike Price B, and buy a second call at Strike Price C. Generally, the asset will be at Strike Price B. All options should have the same expiry date.

Typically, there are two break-even points for this strategy. A trader will make his money back when the current asset price reaches Strike Price A with net debit paid, or when it reaches Strike Price C minus the net debit paid.

Long Butterfly Spread with Puts

The second strategy is the long butterfly spread, using put instead of call options. This means that a trader buys a put at Strike Price A, sells two puts at Strike Price B, and buys another put at Strike Price C. Generally, the asset will be at Strike Price B, much like the long butterfly spread with calls. All options should also have the same expiry date.

Typically, there are two break-even points for this strategy. The first one is when the current asset price reaches Strike Price A with the net debit paid. The second one is when the price reaches Strike Price C minus the net debit paid. Either way, the best outcome is when the asset price is exactly at Strike Price B when the options contracts expire.

Skip Strike Butterfly with Calls

The third strategy is the skip strike butterfly, using call options. Some people may refer to this strategy as a ‘broken wing’ because of the resembling asymmetrical profit-loss diagram.

To set up a skip strike butterfly with calls, a trader buys a call at Strike Price A. They then sell two calls at Strike Price B, skip over Strike Price C, and finally, buy a second call at Strike Price D. All the options contracts should have the same expiry date, and generally, the current asset price will be at or below Strike Price A.

With this strategy, in essence, you sell a short call spread to pay for the butterfly. In this situation, a trader uses the strategy when they are slightly bullish. They have a slight directional aspiration, and they want the asset to rise until Strike Price B and then stop, which is when they can take the most profit.

Skip Strike Butterfly with Puts

The fourth strategy is the skip strike butterfly, using put options. It is like the previous strategy, and its asymmetrical profit-loss diagram similarly resembles a broken wing.

To set up a strike butterfly with puts, a trader buys a put at Strike Price A. They then skip Strike Price B, sell two puts at Strike Price C, and buy a second put at Strike Price D. All the options contracts should again have the same expiry date, and generally, the current asset price will be at or below Strike Price D.

With this strategy, in essence, you sell the short put to pay for the butterfly. In this situation, a trader uses the strategy when they are slightly bearish. They have a slight directional aspiration, and they want the asset price to drop until Strike Price C and then stop, which is when they can take the most profit.

Iron Butterfly

Finally, the fifth strategy is the iron butterfly. Traders use this strategy when they anticipate a relatively stable market with minimal movement within a certain timeframe.

To set up an iron butterfly, a trader buys a put at Strike Price A, sells a put at Strike Price B, sells a call at Strike Price C, and buys a call at Strike Price C. Generally, this takes place when the asset price is at around Strike Price B. Again, all the options contracts should have the same expiry date.

This is a complex strategy with a few purchases in different directions. Therefore, it is recommended that only seasoned options traders take it on. Otherwise, it can be confusing and difficult to manage.

With this strategy, in essence, you break even when the current asset price reaches Strike B, either plus or minus net credit. The best-case scenario is when the asset price reaches Strike Price B exactly, so that all four options can expire worthlessly.

The bottom line

The butterfly strategy hinges on minimal movement in the market. Therefore, many traders like to opt for more stable assets when using the butterfly. For example, if they are looking to trade stocks, they may trade indices instead, which are generally more stable and less prone to massive fluctuations. Regardless, the most important thing is to be educated in the strategy and understand how it works before diving in. The fact is that most options traders lose money, and you should always trade with caution.

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