Reverse Butterfly Spread Option Strategy
What are the characteristics of this option strategy?
The reverse butterfly spread option strategy is a low cost advanced option trading strategy that involves buying and selling both puts and calls on the same underlying with the same expiration. The risk is limited and the potential reward can be high if the options expire in the money. 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 spread option strategy is a neutral strategy since it profits when the underlying stock moves either up or down, as long as the stock moves enough to become in-the-money either above or below the strike prices of the options.
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. This strategy can also be used when the investor wants to make a potentially high return on the stock with limited risk.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
A reverse butterfly spread option typically has a high probability of profit (around 66%) if the stock moves in the right direction. The risk-reward ratio of the strategy is typically low, as the maximum profit is usually far lower than the maximum risk.
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, as the profit potential is usually limited and the risk involved is usually quite high. This strategy is usually used as a longer-term play with the goal of generating large returns after the underlying stock moves in the desired direction.
How do I know when to exit this strategy?
The best time to exit the strategy is when the underlying stock moves close to either of the strikes, so that the remaining time value of the options is minimal and the potential for additional profit is reduced.
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 is bullish on the stock decides to open a reverse butterfly spread option by buying 1 at the money call contract with a strike price of $50, writing 2 out of the money calls at a higher strike price of $52 and buying 1 out of the money call at a lower strike price of $48. The cost of the strategy is the premium paid for the call options ($2.50 + $1 – $0.50), or a net cost of $3.
If the stock rises to $55 at expiry, the investor will make a maximum profit of $7 on the strategy (the difference between the strike price of the calls minus the cost of the options). If the stock does not move beyond $4 from the current level, the investor’s loss will be limited to the cost of the options ($3).
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)