BetterTrades presents Options Trading

Example	Increase in Volatility	Time Erosion
Sell 2 calls (middle strike)   Buy 1 call (lower strike)   Buy 1 call (higher strike)	hurts position	helps position

The Long Butterfly

When your feeling on a stock is generally neutral because it's been trading in a narrow range, the long butterfly can be a great strategy to use. Like many spreads, the long butterfly is a limited risk, limited reward strategy. What makes the position interesting is its ability to profit in stagnant markets.

Imagine that a stock trading at $75 has been relatively flat for some time. If you think the situation is unlikely to change, you can sell two 75 calls. At the same time, you'd buy one 70 call and one 80 call as a hedge in case the market moved against you. This combination of options creates the long butterfly. The position is considered "long" because it requires a net cash outlay to initiate.

Stock: $75

Sell: Two 75 calls @ $6 for a credit of $1,200 (the body of the butterfly)
Buy: One 70 call @ $9 for a debit of $900 (one wing)
Buy: One 80 call @ $4 for a debit of $400 (other wing)

Total Credits: $1,200
Total Debits: $1,300
Net Debit or Cost of Position: $100 ($1,300 - 1,200)

Note: The same position can be established using puts. However you establish it, all options must have the same expiratoin and be the same price--i.e., calls or puts.

In this case, the maximum profit is achieved at expiration with the stock at $75. At $75, the 75 and 80 calls would expire worthless, and the 70 calls would be worth $500. Thus, you would achieve your maximum profit of $400 ($500 - $100 initial debit). At any price above $80 or below $70, you would experience the maximum loss of $100.

Value At Expiration

Stock Price	Profit (Loss)	Return on Investment**
$65	(100)	(100%)
$70	(100)	(100%)
$71	0	0%
$75	400	400%
$79	0	0%
$80	(100)	(100%)
$85	(100)	(100%)
$90	(100)	(100%)

*The profit/loss above does not factor in commissions, interest or tax considerations.
**The ROI is calculated based on the maximum loss of the position.

Now, let's see what happens when you sell the butterfly.

The Short Butterfly

Example	Increase in Volatility	Time Erosion
Buy 2 calls (middle strike)   Sell 1 call (lower strike)   Sell 1 call (higher strike)	helps position	hurts position

Let's imagine that a stock is trading at $75. You have a feeling the stock is going to make a moderate move, but you aren't sure which way. In this sense, your market sentiment is neutral.

In this case, you might sell the butterfly. Like its counterpart the long butterfly, the short butterfly is a limited risk, limited reward strategy.

Stock: $75

Buy: Two 75 calls @ $5 for a debit of $1,000 (the body of the butterfly)
Sell: One 70 call @ $9 for a credit of $900 (one wing)
Sell: One 80 call @ $2 for a credit of $200 (other wing)

Total Credits: $1,100
Total Debits: $1,000

Net Credit: $100 ($1,100 - 1,000)

Note: The same position can be established using puts.

By rearranging the options, it's easy to see that the butterfly is nothing more than the combination of a bull and bear spread.

Bull Call Spread: Long one 75 call, short one 80 call
Bear Call Spread: Short one 70 call, long one 75 call

Either way you look at it, the body of the butterfly (the inside strike price) is purchased and the wings or outer strike prices are sold. It's considered a short position because you receive a credit of $100 for initiating the trade. This is also the maximum profit. In this case, the maximum profit is achieved at expiration with the stock above $80 or below $70.

Below $70, all of the calls expire worthless and you keep the $100 credit received when you established the position. Above $80, the profit from the 75 calls is exactly offset by the loss from the 70 and 80 calls. Here again, you keep the $100 credit and the rest would be a wash (less commissions of course.)

The maximum loss for this position would occur with the stock at $75. Here, the 75 calls you paid $1,000 for would expire worthless as would the 80 call you sold for 2. To close the position, you'd have to buy the 70 call for 5 (current price - strike price). Given this possibility, the margin requirements for this position typically require you to have at least $500 available in your account. This amount is also the basis for calculating return on investment even though the maximum loss is only $400 ($500 - $100 initial credit).

Value At Expiration

Stock Price	Profit (Loss)	Return on Investment**
$65	100	20%
$70	100	20%
$71	0	0%
$75	(400)	80%
$79	0	0%
$80	100	20%
$85	100	20%
$90	100	20%

*The profit/loss above does not factor in commissions, interest or tax considerations.
**The ROI is calculated based on the maximum loss of the position not including the credit received.