What are the characteristics of this option strategy?
Reverse butterfly spreads are an advanced position built from three strikes of the same option type, all calls or all puts, on the same underlying with the same expiration. The trade sells one option at each outer strike and buys two at the middle strike, which is the mirror image of the long butterfly. The variant that combines calls and puts is the reverse iron butterfly. Both the risk and the reward are limited: the most the position can make is the net credit taken in when it is opened, and that credit is kept only if the stock finishes outside the two outer strikes. The profit potential of a reverse butterfly spread increases as implied volatility increases and decreases if implied volatility decreases.
Is this a bullish, bearish or neutral strategy?
The reverse butterfly is direction-neutral. It does not need the stock to go up or down, it needs the stock to go somewhere: the position profits on a large move either way and loses if the stock settles at the middle strike. It is a bet on movement, not on direction.
Is this a beginner or an advanced option strategy?
This option strategy is considered to be an advanced strategy as it requires understanding of options chains and the ability to manage a higher risk which is associated with advanced option strategies.
In what situation will I use this strategy?
The reverse butterfly spread option strategy can be used in any situation when the investor wants to take a view that the underlying stock will move up or down, but does not have a strong conviction on the direction that the market will go. It suits a trader who wants a defined-risk way to be long movement, provided they accept that the payoff is capped at the credit received.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
A reverse butterfly spread typically has a LOW probability of profit, since the stock must finish more than the credit received away from the middle strike, and the full credit is only kept if it finishes past one of the outer strikes. The risk-reward is correspondingly low, because the maximum profit, which is the credit, is usually far smaller than the maximum risk, which is the strike width less that credit.
How is this strategy affected by the greeks?
The reverse butterfly spread option strategy is largely affected by the gamma and theta of the underlying options. The Gamma indicates the rate of change of the delta when the underlying moves and thus affects the position’s delta when the underlying moves. Theta, on the other hand, indicates the rate of time decay and thus affects the profitability of the position over time.
In what volatility regime (i.e VIX level) would this strategy be optimal?
This option strategy is typically more profitable in higher volatility markets. In lower volatility markets, the options have less time value and the potential profit from the strategy is therefore reduced.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
This strategy can be adjusted in two ways when the trade goes against you. The first is to roll out of the position and move the strikes further away from the current underlying price. The second is to adjust the delta, ie reduce the delta if it is too high or increase it if it is too low, by buying or selling options respectively. While it is possible to adjust this strategy, it can be difficult to do so as the size of the options involved can change significantly on account of the high Gamma of this strategy.
Where does this strategy typically fall in the range of commissions and fees?
The commissions and fees for this strategy are typically in the mid to low range, as the cost to open and close the trade is relative to the number of options being bought and sold.
Is this a good option income strategy?
The reverse butterfly spread option strategy is not typically used as an income strategy. It does take in a credit, but the credit is small next to the loss at the middle strike, and the position only pays if the stock leaves the range. It is used as a play on movement rather than as a repeatable source of income.
How do I know when to exit this strategy?
The best time to exit is once the underlying has moved decisively past one of the outer strikes, since almost all of the available profit is captured there and holding on adds nothing but the risk that the stock comes back to the middle strike. The other exit is a discipline exit: if the stock is sitting on the middle strike as expiration approaches, the position is heading for its maximum loss and closing early recovers part of it.
How will market makers respond to this trade being opened?
Market makers will typically look for opportunities to take the other side of the trade when the reverse butterfly spread strategy is opened. They will try to reduce the potential profit for the investor by narrowing the bid/ask spread between the different option strikes.
What is an example (with calculations) of this strategy?
Consider the option chain of a stock XYZ. The stock is currently trading at $50. An investor who expects a large move but is unsure of direction opens a reverse butterfly on the call side: sell 1 in-the-money $48 call for $2.60, buy 2 at-the-money $50 calls for $1.40 each, and sell 1 out-of-the-money $52 call for $0.70, all in the same expiration. The premium received is $2.60 plus $0.70, or $3.30, against $2.80 paid for the two long calls, so the position opens for a net credit of $0.50 per share, or $50 for the spread.
That $50 credit is the most the position can make. Below $48 every call expires worthless and the credit is kept in full. Above $52 the legs offset each other exactly: at $55 the short $48 call is worth -$7, the two long $50 calls are worth +$10 and the short $52 call is worth -$3, a net of zero, so again the credit is all that is left. The maximum loss occurs when the stock finishes at the middle strike at expiration, and equals the distance between the outer and middle strikes minus the net credit received. At $50 the short $48 call is worth -$2 against the $0.50 credit, a loss of $1.50 per share, or $150 per spread, which is three times the credit taken in. The break-evens are $48.50 and $51.50, which sit $0.50 inside each outer strike, so the stock has to move at least $1.50 away from the middle strike before the trade makes anything at all, and it has to finish past $48 or $52 to keep the credit in full.
Conclusion
The reverse butterfly spread option strategy is an advanced option trading strategy that can be used when the investor wants to take a view that the stock will move up or down, but is not sure of the direction. The strategy is usually profitable in higher volatility markets and the risk-reward ratio is typically low. Market makers may take the other side of the trade and try to reduce the potential profit for the investor.
For investors who are new to this strategy and would like to learn more, MarketXLS is an excellent platform to gain knowledge and expertise in options trading. MarketXLS provides access to options data, calculators and analytics tools that can help investors manage their options trades more efficiently and make more informed decisions.
Here are some templates that you can use to create your own models
Reverse Iron 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
Are Butterfly Spreads Right for You?
Reverse Iron Butterfly Options Strategy (Using MarketXLS Template)