Fly, Little Butterfly: Diminishing Risk in a Volatile Market

Today, I want to talk about one of my very favorite low risk, high reward directional option strategies, the Butterfly.

The strategy is long strike A one time, short strike B twice and long strike C once. The strategy is all puts or all calls. You can look at it as a combination of two vertical spreads, one long and one short. You want the long vertical to expire at maximum value and the short vertical to go out worthless; In other words, expiration exactly at strike B. Your risk is limited to the debit paid.

It is important that all strikes be equidistant from each other. And my rule of thumb is never to pay more than 10 percent of the strike interval. So, $1 in a 10 point ‘fly, $.50 in a 5 point ‘fly, etc…. This gives us a very nice 1:9 risk/reward ratio.

To be able to do this, all parts of the ’fly will be out of the money, making it a directional trade, albeit an inexpensive one.

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Let’s look at a real time example (March 18, 10:30 CDT) using Apple (AAPL). Let’s say I think AAPL (now trading at 529.25) has had too nice a run recently and will head back to 500 by July.

I can buy the July 520 put one time for 24. I then sell the July 500 put twice at 16 and buy the July 480 put one time at 10. This means I have paid a two point debit for this butterfly, exactly at my 10 percent of the strike interval guideline. This two points (or $200 per butterfly) is also the most I can lose where ever AAPL expires in July. An expiration at 500 exactly makes me 18, or $1800. This gives me the 1:9 risk reward ratio I am looking for.

Moreover, as AAPL approaches my 500 target, the butterfly will widen. One of my basic trading rules is always to take off half a position when doing so lets the other half run for free. In trader’s parlance we call this “taking a double” and it is simply good risk management. So, if I have the ‘fly on 10 times and it widens to four, I sell five and let the other five run. Hey, why not play with the house’s money?

In fact, if I think a stock will be super volatile I can put on two butterflies, one call and one put. As soon as one moves enough to pay for the other, I take it off and let the other one run.

What if AAPL isn’t going back to 400 but will be over 600 in July? Using today’s prices I can buy the July 580 call once at 9.25, sell the 600 call twice at six and buy the 620 call once at 3.75. This means I risk one to make 19, an even better risk/reward ratio. Of course, this is because the call butterfly is further out of the money.

Hey, if AAPL does turn super volatile, both ‘flys could double by expiration. Unlikely, I admit, but stranger things have happened.

In any case, I hope that I have shown what a simple, low risk, directional play a butterfly can be. So, open that chrysalis and let the butterflies fly!

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