What are the characteristics of this option strategy?
Butterfly spreads are primarily a neutral strategy, used to keep risk defined while capitalizing on low volatility markets. The position is composed of four options of the same type, all calls or all puts, on the same asset with the same expiration date and across three equally spaced strike prices. It involves buying one lower strike, selling two at the middle strike, and buying one higher strike. No extra protective put is part of the position.
Is this a bullish, bearish or neutral strategy?
The butterfly option strategy is a neutral strategy. It’s designed to take advantage of relatively low volatility, with the loss capped at the debit paid, so it’s not suitable for taking directional bets on an asset.
Is this a beginner or an advanced option strategy?
The butterfly option strategy is considered to be an intermediate strategy, meaning it’s not too difficult to learn but still requires some knowledge of market and option behavior.
In what situation will I use this strategy?
This strategy is typically used when a trader expects the price of an underlying asset to stay relatively steady and not make a dramatic move. This is especially useful when implied volatility is low, as the strategy can capitalize on time decay and low option premiums.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
The cost of entry is small, because the two short middle-strike options pay for most of the wings, and the loss is capped at that debit. The reward relative to that debit can be large, but only in a narrow band around the middle strike. The probability of profit is low rather than high: the stock has to finish between the breakevens, and the full payout arrives only if it finishes exactly at the middle strike. A butterfly is a cheap, defined-risk bet on the price pinning, not a high-probability trade.
How is this strategy affected by the greeks?
The butterfly option strategy is most affected by gamma and vega, and moderately affected by theta and delta. Gamma measures the rate of change of an option’s delta. It is delta, not gamma, that acts as a rough proxy for the chance of an option expiring in-the-money. A long butterfly carries most of its gamma around the middle strike, so the position value swings fastest when the stock sits near the body of the fly close to expiration. Vega, meanwhile, shows the sensitivity of an option’s price to changes in volatility. The butterfly strategy is also moderately sensitive to theta, as it is designed to benefit from time decay of option prices, and delta, which measures the rate of change of an option’s price to changes in the asset’s price.
In what volatility regime (i.e VIX level) would this strategy be optimal?
This strategy is typically optimal when implied volatility is low and not expected to move significantly. The low volatility environment allows for the low-cost construction of the strategy and a lack of significant change in implied volatility keeps option premiums from skyrocketing and erasing returns.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
Adjusting this strategy when the trade goes against you is relatively simple and straightforward. If the underlying asset moves against you, the loss is still capped at the debit you paid, so adjusting is a choice rather than a necessity. Adjust by rolling the tested side: buy back one of the short middle-strike calls, or close the whole butterfly and re-open it centred on the new price. Never close the long wings while leaving short calls open, because the remaining short calls are then naked and carry unlimited upside risk.
Where does this strategy typically fall in the range of commissions and fees?
Since the butterfly option strategy requires four separate transactions, commission and fees can be a factor when trading this strategy. Generally speaking, this strategy falls in the medium range of commissions and fees as it requires four transactions.
Is this a good option income strategy?
The butterfly option strategy is not an option income strategy. It is opened for a net debit rather than a credit, so nothing is collected up front, and the gain has to come from the underlying pinning near the middle strike by expiration. Traders who want a repeatable credit in a sideways market usually sell a spread instead.
How do I know when to exit this strategy?
The best time to exit this strategy is when the underlying asset starts to make a significant move in either direction. This is indicative of a shift in the market and increased implied volatility, which cuts into the strategy’s potential returns.
How will market makers respond to this trade being opened?
Market makers do not take a view on your trade. They quote each leg and earn the bid-ask spread, and because a butterfly has four legs you cross that spread four times if you leg in. Enter and exit the position as a single butterfly order with a limit price so the fill cost does not eat the payout.
What is an example (with calculations) of this strategy?
An example of the butterfly option strategy is if you want to speculate on the price of stock ABC, which is currently trading at $50 per share. You could buy a 45 Call, sell two 50 Calls, and buy a 55 Call, all with the same expiration date. This would cost you $2 per share ($200 per butterfly) in total, plus commissions and fees. The most you can make is the $5 wing width minus the $2 debit, or $3 per share ($300), and only if ABC finishes exactly at $50. The breakevens are $47 and $53, so ABC finishing between $45 and $47 or between $53 and $55 still loses money, and the full $2 debit is lost at or beyond $45 and $55.
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Here are some templates that you can use to create your own models
Iron Butterfly Option Strategy
Long Butterfly with Calls Option Strategy
Long Butterfly with Puts Option Strategy
Butterfly for Shorts Spread
Reverse Iron Butterfly Spread
Short Butterfly Spread
Reverse Iron Albatross Spread
Search for all Templates here: https://marketxls.com/templates/
Relevant blogs that you can read to learn more about the topic
Making Sense of Option Time Value
Are Butterfly Spreads Right for You?
Maximizing Profits with a Bull Put Spread Strategy
Options Trading (Strategies)
Get RealTime Updated Option Prices