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How to trade a Butterfly

by Uncle Bob Williams

Description | Graph | Example | Trade Finder Rules
Pricing | Trade Monitor Rules | Conditional Orders

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Butterfly Strategy Description:

A Butterfly works by Selling 2 contracts on the Strike near the current Market price with the current Expiration Date, and then Buying 1 contract on either side, approximately 1 Standard Deviation away with the same Expiration Date. The 'wings', the positions we buy, must be the same distance away from the Short strike, otherwise it will create an uneven Butterfly with a Maintenance requirement.

We can do Butterfly trades on PUTs and CALLs, and we generally only stay in the trade for 17 to 20 days.

A Butterfly Spread is a DEBIT spread: we pay to enter the trade and there is no maintenance requirement. The value of our Long positions will always cover any potential loss from the Short positions. Therefore, the maximum amount of loss possible on a Butterfly trade is the amount we pay for the trade.

Let's take our fictitious company AcmePlus as an example. AcmePlus stock is currently trading at $100 per share. We can Buy 1 Contract of the JUNE 95 CALL for $5.50 per share, and we Sell 2 Contracts of the JUNE 100 CALL for $2.25 per share, and we can Buy 1 Contract of the JUNE 105 CALL for $0.40 per share. [Remember that Options Contracts represent 100 shares of stock.]

=> When we Buy 1 CONTRACT of the JUNE 95 CALL Strike for $5.50, we will have to pay $550 immediately to cover that purchase. (We bought 1 CONTRACT of the JUNE 95 CALL for $5.50 PER SHARE, and there are 100 shares in 1 CONTRACT = $550.)

=> When we Sell 2 CONTRACTS of the JUNE 100 CALL Strike for $2.25, we will get paid $450 immediately into our Brokerage account. (We sold 2 CONTRACTS of the JUNE 100 CALL for $2.25 PER SHARE [$225 * 2 = $450].)

=> When we Buy 1 CONTRACT of the JUNE 105 CALL Strike for $0.40, we will have to pay $40 immediately to cover that purchase. (We bought 1 CONTRACT of the JUNE 105 CALL for $0.40 PER SHARE, and there are 100 shares in 1 CONTRACT = $40.)

=> Our Gross Cost = $140 ($550 + -450 + 40)

=> The maximum possible gross loss is $140. This is what would happen if the Market price of AcmePlus was above or below the max loss point at the JUNE Expiration: the Expiration of our Short Strike.

We can see below on the graph of a Butterfly trade the location of both the max loss points and the break-even points.

The maximum profit on a Butterfly Spread is at our Short Strike—in our example it is the 100 Strike. In many Butterfly Spreads, the maximum profit at expiration can be over 250%, but don't get too excited just yet. We generally only hold Butterfly trades for 17 to 20 days, and then we exit. If all goes well, we can expect to exit with a nice profit of 10% to 20%.

It is possible to hold a Butterfly spread on a Cash Settled Index until Expiration.

SPREAD TRADES:

When we trade Options, we don't have to go through the process of buying and selling the individual Options of our Butterfly or other spread trades. We can make a "Spread" order, where we specify what Options we want to Buy and Sell, and we can say what NET amount we want to get. (See the explanation in the Condor and Calendar sections.)

On a Butterfly, we can generally get better pricing by splitting the trade up into 2 Vertical Spreads:

# 1: Vertical Spread with: 1 Long and 1 Short.

# 2: Vertical Spread with: 1 Short and 1 Long.

COST & MARGIN REQUIREMENTS:

=> Debit Spread. We pay to enter the trade.

=> Maintenance Requirement: There is no maintenance. Our maximum loss is the amount we paid for the Butterfly spread.

HOW WE PROFIT:

We profit on a Butterfly trade through the reduction of Time Premium of our Short positions during the 17 to 20 days that we are in the position. Since one of our Long positions is In The Money, almost all of the cost of that Option will be Intrinsic value. However, the amount that the position is In The Money, the value of our Short Positions, will be almost all Time Value. As we get closer to Expiration, we will be able to sell our Long positions for about what we paid for them. However, it will cost us less to buy back our Short positions, and we end up with a profit. In essence, we buy the Butterfly at a low price, and then sell to close it later at a higher price.

HOW WE CAN HAVE A LOSS:

=> When the underlying has unusual price movements in one direction that force us to remove our positions early.

=> When the Implied Volatility (IV) goes up / trends up.

PROBABILITIES:

Butterfly Trades have probabilities of success around 50%.

It is possible to combine multiple Butterfly positions to widen the area of profitability. It is also possible to remove and replace Butterfly's according to Market movements.

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Butterfly Graph:

Uncle Bobs Money Sample Butterfly Trade Graph

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Butterfly Example:

The current price of AcmePlus stock is $100 per share.

Example: CALL Butterfly

We BUY 1 Contract | ACMEPLUS | JUNE | 95 | CALL | $5.50 per share

We SELL 2 Contracts | ACMEPLUS | JUNE | 100 | CALL | $2.25 per share (-225 * 2 = -450)

We BUY 1 Contract | ACMEPLUS | JUNE | 105 | CALL | $0.40 per share

GROSS DEBIT = $140 ($550 + -450 + 40)

MAINTENANCE = zero (There is no maintenance on Butterflys; the maximum loss is what you paid for the trade.)

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Butterfly Trade Finder Rules:

Butterfly Trades place the Short Strikes near the current price of the underlying, and the Long Strikes are equally distant at approximately 1 Standard Deviation for 17 Days away from the Short Strikes. It is held for 17 to 20 days. We can do Butterfly trades on PUTs and CALLs.

The Uncle Bob's Money Trade Checklist and Trade Finder automatically check all the relevant factors.

view: Trade Finder screen shots

TIME FACTORS:

=> Time to Enter Trade: 35 days until 25 days prior to expiration

=> Preferred Time to Enter Trade: 30 days prior to expiration

=> Minimum Time Premium: N/A

=> Earnings and News: On Stocks: no news, no Earnings, no mergers, no splits, no takeovers, etc. Any one of those items can cause the price of the Underlying to jump.

=> Time In Trade: 17 to 20 days. Butterflys can be held until Expiration.

VOLATILITY FACTORS:

=> Maximum IV: Less than 35.

=> IV Range: Any IV value is OK. High IV is OK if you think it will go down.

=> IV Channeling: Channeling for at least 45 days.

=> IV Trend UP: Fair to Bad.

=> IV Trend DOWN: Good.

=> IV Skew Range: N/A

PRICE FACTORS:

=> Minimum Underlying Price: $75. If the price of the underlying is too low, the price of the Options will be too low, and there won't be enough Time Premium decay to create a healthy profit.

=> Strike Pricing: Long positions approximately 1 Standard Deviation based on 17 days Expiration. Evaluate the price of PUTs vs. CALLs, choose whichever has the best pricing.

=> Minimum Premium: N/A

=> Price Movements in Last Week: +/- 5%

=> Price Movements in Last Month: +/- 10%

=> Price Movements in Last 3 Months: +/- 15%

=> Delta Neutral: For Advanced Traders, it is recommended to be Delta Neutral when placing the trade. Add extra Long positions to balance the Delta, but be careful not to reduce the Theta by more than half.

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Butterfly Price Negotiation:

=> Beginning traders can put in all 3 legs of the Butterfly as one trade to start. It is best to trade one Spread at a time: Trade the 2 vertical Spreads separately. (LONG and SHORT as one Spread, and the SHORT and LONG as the other Spread)

=> Determine the highest price to pay before starting to trade.

=> Start at the Mid Price and wait a few minutes. (Be more patient if you have one large order with all 3 legs.)

=> Increase price by the smallest amount possible ($0.01, $0.05, etc.), and wait before changing the price again. Never exceed the highest price limit.

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Butterfly Trade Monitor Rules:

The Uncle Bob's Money Trade Monitor automatically shows the profit level for each strategy and checks the relevant factors.

view: Trade Monitor screen shots

=> If the underlying reaches the Expiration break-even point, exit the trade.

=> If the IV Trend goes UP, exit the trade.

=> If the price movement of the underlying exceeds the Trade Finder values, exit the trade.

=> If the Time in Trade exceeds 20 days, the position should be monitored very closely or exit.

=> Butterfly trades on Cash Settled Indexes can be held until Expiration.

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Butterfly Suggested Conditional Orders:

The Uncle Bob's Money Trade Monitor automatically shows the suggested break-even points, which are used for placing Conditional Orders.

The current price of AcmePlus stock is $100 per share.

CALL Butterfly

We BUY 1 Contract | ACMEPLUS | JUNE | 95 | CALL

We SELL 2 Contracts | ACMEPLUS | JUNE | 100 | CALL

We BUY 1 Contract | ACMEPLUS | JUNE | 105 | CALL

break-even up-side: 103

break-even down-side: 97

(The break-even points are listed on the Uncle Bob's Money Trade Monitor Page.)

STEP A) Select "Single Order"

STEP B)

=> Select the Butterfly Trade, and create a 'closing order'. (You can manually select the opposite spread to close the position if your Broker doesn't have the 'closing order' possibility.)

=> Time in Force: GTC (Good 'Til Cancelled)

=> Price Rules: Market (We don't want to set a limit price, because we don't know what the pricing will be and we want to close this position if the underlying hits our break-even point.)

=> Submit at Specified Market Condition #1: When the "MARK" of the Underlying is "AT OR ABOVE" price of "103" (Make sure to use the Up-side break-even as listed in the Uncle Bob's Money Trade Monitor for your own trade.)

=> Submit at Specified Market Condition #2: When the "MARK" of the Underlying is "AT OR BELOW" price of "97" (Make sure to use the Down-side break-even as listed in the Uncle Bob's Money Trade Monitor for your own trade.)

Your broker will describe this trade as:

1. Wait until at least the one of the following conditions is satisfied (this order will show a WAIT COND status during waiting):

*) mark price of the security is less or equal to 97.00;

*) mark price of the security is greater or equal to 103.00;

2. Submit the following order: SELL -1 BUTTERFLY ACMEPLUS JUNE 95/100/105 CALL at current market price. The order is valid until it is either filled or cancelled.

STEP C) Confirm that the trade was entered correctly, and submit the trade.

We now have a conditional order that will close our Butterfly trade if the underlying price hits ONE of our break-even points.

NOTE: If we decide to manually exit positions, we must first cancel ALL conditional orders that we placed on those positions.

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