What are the characteristics of this option strategy?
Short butterfly spreads are limited risk, limited profit positions built from a bear spread and a bull spread across three strikes. In this strategy, the investor will sell a put at a lower strike price, buy two near-the-money puts, and sell another put at a higher strike price, all for a net credit. That leaves the investor long volatility at the body and short volatility at the wings, so the position wants a large move and takes its maximum loss if the stock pins the middle strike.
Is this a bullish, bearish or neutral strategy?
The Short Butterfly Option Strategy is a long-volatility strategy. It performs best when the stock finishes outside the wings of the butterfly by expiration, and takes its maximum loss at the body.
Is this a beginner or an advanced option strategy?
The Short Butterfly Option Strategy is considered an advanced option strategy due to the multiple options positions that need to be opened and managed simultaneously. Because the strategy involves the combined actions of two separate long options positions and two separate short positions, it can be difficult to manage and interpret and therefore sometimes is best left to advanced options traders.
In what situation will I use this strategy?
This strategy is best used when an investor expects a large move and expects the stock to finish outside the outer strike prices of the butterfly. Time decay works against the position while the stock sits near the body.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
The Short Butterfly Option Strategy has a small capped reward against a much larger capped risk, and a low probability of profit. The maximum profit is the net credit received when entering the trade, and that credit is usually a small fraction of the wing width. The maximum risk is the distance between the wing and the body, times 100, less that credit, which is close to $1,000 per spread on a $10 wide butterfly. Both sides are defined, but the loss can be nine or ten times the credit, and the stock has to finish outside a wing for the trade to pay.
How is this strategy affected by the greeks?
The greeks will affect this strategy in two ways: (1) Delta, which sits near zero while the stock is at the body and turns directional as the stock travels toward one of the wings. (2) Theta, which works against the position while the stock is near the body, because the butterfly you are short gains value as expiration approaches, and only works for the position once the stock has moved outside a wing.
In what volatility regime (i.e VIX level) would this strategy be optimal?
This structure is best entered when implied volatility is low and expected to rise. A butterfly is worth more when the market expects the stock to sit still, so a quiet volatility regime gives the larger credit, and the position then profits if volatility expands and the stock travels outside a wing. Selling the butterfly into already elevated volatility collects less for the same maximum loss.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
This trade goes against you when the stock settles at the body, so the adjustment is to move the structure away from the stock, not toward it: roll the whole butterfly up or down so the body sits away from where the stock is trading, or close it and take the smaller loss while time value remains. Rolling the body onto the current stock price does the opposite of what you want, since the body is the point of maximum loss. All of these are four leg orders, so they are straightforward to place but rarely cheap.
Where does this strategy typically fall in the range of commissions and fees?
The Short Butterfly Option Strategy falls on the higher end of the commission and fees range. It takes four contracts to open and usually four more to close, and in an all put butterfly a finish below the lowest strike leaves every leg in the money, which brings assignment and exercise fees with it. Those costs are large relative to the small credit collected.
Is this a good option income strategy?
No. The Short Butterfly Option Strategy is opened for a credit, but it is not an income trade. Time decay works against it while the stock sits near the body, and it needs a large move to keep the credit, which is the opposite of how a premium selling income position behaves.
How do I know when to exit this strategy?
An investor should consider exiting once the stock price moves back toward the body of the butterfly, since the body is where the position takes its maximum loss. A move away from the body is what the trade is designed to profit from.
How will market makers respond to this trade being opened?
Market makers will usually fill this package readily, since all three strikes are standard and the position is easy for them to hedge. Opening it signals a view that the stock is about to move, not a low risk trade, and with four legs the quality of the fill on the package matters more than it does on a single option.
What is an example (with calculations) of this strategy?
Here is an example of the Short Butterfly Option Strategy from MarketXLS
An investor is looking to initiate a Short Butterfly Option Strategy on Google for the expiration of 45 days. The investor sells a $950 put, buys two $960 puts, and sells a $970 put. The investor sells the $950 put for $20.50 and the $970 put for $30.50, and buys the two $960 puts for $25.00 each, for a net credit of $100. The maximum profit is that $100 credit, realised below $950 or above $970, and the maximum loss is $900 at $960 (the $1,000 wing width less the $100 credit).
The two breakevens are $951 and $969. At expiration, if the stock is trading below $951 or above $969, the investor makes a profit, and anywhere in between the position loses, with the worst case of $900 right at $960.
Conclusion
The Short Butterfly Option Strategy is an advanced option strategy that involves the simultaneous action of two separate long options positions and two separate short positions. It is a long volatility strategy, not a neutral one: it works best when the stock finishes outside the outer strikes and takes its maximum loss at the body. Both the profit and the loss are capped, but the loss can be many times the credit received, and the probability of profit is low because the stock has to travel for the trade to pay.
MarketXLS can help to easily obtain the necessary parameters for this strategy, such as the strike prices, the time to expiration and the premiums for the options. With a comprehensive options data platform, MarketXLS makes it easier and faster to trade options and analyze potential outcomes. With MarketXLS, you can also easily adjust the strategy when the trade goes against you.
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
Short Butterfly Spread
Reverse Iron Butterfly Spread
Butterfly for Shorts Spread
Search for all Templates here: https://marketxls.com/templates/
Relevant blogs that you can read to learn more about the topic
Get RealTime Updated Option Prices
Making Sense of Option Time Value
2 Leg Option Strategies
Maximizing Profits with a Bull Put Spread Strategy
Are Butterfly Spreads Right for You?