Much like the condor or iron condor, the butterfly spread is another popular trade among options traders. This spread also has an “iron” version (a spread that incorporates calls & puts) and has the potential to earn more than the iron condor at a quicker rate. The larger and quicker returns also come with increased risk so this trade requires more management than an iron condor.
A butterfly can be placed out of the money (OTM) in order to incorporate a directional bias or it may be placed at the money (ATM) and be neutral on direction. I’ll be discussing a hypothetical ATM butterfly on the S&P 500 index (SPX) here. The basic position is as follows:
Optimal Conditions:
- Implied volatility (IV) is headed lower
- Skew is relatively flat
- Underlying will not move a whole lot
A relatively flat put skew means that the OTM puts are cheap relative to ATM. Take a look at this post if you have questions on skew. In a butterfly, one is selling the ATM contracts (selling the ATM contract’s IV) and buying the OTM contracts (buying the OTM contract’s IV). So, it makes sense to buy relatively cheap and sell relatively high.
Steps:
- Calculate the standard deviation of the underlying using the IV of the contract month & time remaining to expiration of the contract.
- Place short strike using the ATM contract and wings at 1 standard deviation.
The Position:
SPX AUG 12 1335/1385/1435 Put Butterfly
+1 AUG 12 1440 PUT at $54.85
-2 AUG 12 1380 PUT at $20.00
+1 AUG 12 1320 PUT at $5.85
for a total debit of $20.70 per butterfly. The risk profile of the spread looks like this (click to enlarge):
Profit Target:
I generally have a profit target on these trades of 10% return on risk (ROR). I’ll discuss adjustments and management techniques in part 3.
Iron Butterfly
The Iron Butterfly is essentially the same thing as the standard butterfly except that one is using calls and puts. Using the above example, the iron butterfly position would look like this:
+1 AUG 12 1440 CALL
-1 AUG 12 1380 CALL
-1 AUG 12 1380 PUT
+1 AUG 12 1320 PUT
The risk and profit may differ a bit from the standard version depending on the bid/ask spreads of the underlying. In general, the risk and profit will be very similar except you receive a credit for the iron version and it requires margin, much like the iron condor.
Part 2 will discuss how the greeks of this position are affected by price action, implied volatility movement, and the passage of time. Part 3 will discuss management, adjustments, and profit targets. Here’s a video where I explain the butterfly spread (you can watch it in HD):
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Adam Singh
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http://www.vicmora.com Victor Mora
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Adam Singh
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