Monday, March 7, 2011

Options 101: The Butterfly

A butterfly is a spread consisting of 3 legs with exercise prices that are equally spaced apart. All options are either calls or all puts with the same expiration. The ratio is always 1x2x1. In a long butterfly, the outside options are purchased (the wings) and the inside options are sold (the guts). An important characteristic of all butterflies is the limited risk. The cost to put on a long butterfly is the debit which is the max risk. The max gain is the difference between the strike prices minus the debit. The max gain occurs if at expiration the underlying stock price pins to the exercise price of the short calls. If a long butterfly is executed for a credit, the only risk is the execution risk. A large move in the underlying generally hurts, an increase in volatility hurts, and the passage of time helps.




In a long butterfly, the upper break even point is the strike price of the higher strike long call minus the debit. The lower break even point is the strike price of the lower strike long call plus the debit.
In a short butterfly, the outside options are sold and the inside options are bought. The cost to put on a short butterfly is the credit. The max risk is the difference between the strike prices minus the credit. The max gain is the credit. Just the opposite of a long butterfly, a large move in the underlying generally helps, an increase in volatility helps, and the passage of time hurts.



If a trader foresees a quiet market, he will prefer a butterfly. All butterflies are worth their maximum amount when the underlying contract is right at the inside exercise price at expiration. The trader will also have defined his risk.




Above is an example of the $4.5/5/$5.5 long butterfly. The trader would be long one $4.5 and $5.5 call and short 2 $5 calls. The costs to put on this butterfly is the debit, which is the max risk. The max gain is the difference between the strike prices minus the debit. The max gain occurs at an underlying price of $5 at expiration.

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