The most important advantage of a Butterfly is that it allows further Cost Basis Reduction. Butterfly Spreads are traditionally done with either all Calls or all Puts, and involve three Strikes Prices for each spread. The strategy is named after the concept that one of these Short/Long Strikes makes up the body and the other 2 Long/Short Strikes makes up the wings to form a Butterfly. An important criteria for the strategy is that the Expiration months and increments between Strike Prices for all Options should be the same.

Set up

• Sell two ATM Call Options with a middle Strike Price.

• Buy one OTM Call Option with higher Strike Price.

        • Buy one ITM Call Option with lower Strike Price.

• Use the same underlying asset and the same contract Expiration Date based on Analytics accuracy.

• Select Strike Prices based on Probability of Success, and Tradespoon’s     analytics.

For the purpose of set up you can think of the Butterfly as two Spreads: a Debit Spread and a Credit Spread. Or better still- a Debit Spread where the Long Call is a lower Strike Price and a Credit Spread where the Long Call is a higher Strike Price.

Example
To select a Strike Price you have to identify where the stock is gravitating towards by the selected Expiration Month. As you can see in the Profit/Loss Calculator given below, the maximum profit is when you are reaching the Short Strike Price. So, the peak of the profit and loss is the middle Strike Price where the Short Strike is. The wings are in-the-money and out-of-the-money calls.

Maximum loss occurs when the price drops either below the Lower Strike Price or when it moves above the Higher Strike Price. The Breakeven Points are the two points where the Strike Price intersects the x-axis.

Always keep in mind that even though the Butterfly is a market neutral strategy, where you just have to make sure that the Strike Price does not move below or above the Long Strikes, it can also be executed as a directional trade if the body of the fly is significantly above or below the currently underlying asset price.

Key takeaways

• Market Outlook is directional to the Short Strike that constitute the body. Even though Butterfly is a market neutral strategy, you can use Tradespoon’s forecasts and analytics to find where the Stock will be gravitating towards by the Expiration Date. It is a perfect strategy- especially if there is no binary event.

• The Risk is limited on both the Upside and Downside.

• The Reward is also limited.

• It is a Debit Strategy and has a reduced Cost Basis.

• Always review the Implied Volatility Rank to know when to execute the strategy.

• It is a great strategy after especially after earnings when you have a low Implied Volatility Rank.

• Always use the Stock Forecast tool to find optimal middle Strike Price.