Lessons from the Pros

Butterfly: Part I

This newsletter is the first in a series of several articles that will address in greater detail the option strategies known as Butterflies. In this one, I am trying to introduce the basic concept of a Butterfly without providing any specific examples. Specific examples will follow in the subsequent newsletters.

Typically, the option trader would place the Butterfly spreads when they are not anticipating huge movement within the specific time frame. One of the easiest ways to describe a Butterfly spread is by making reference to vertical spreads. As I wrote in the five article series, Verticals: Part I to Part V, the vertical spreads could be either debit or credit spreads. A Butterfly is essentially a combination of a debit and a credit spread. However, both types of spreads must be built by the same option class; either the calls or puts. In other words, there are call Butterflies and put Butterflies. For simplicity’s sake, I will not venture into explaining what an Iron Butterfly is until I have covered in detail the variants of a regular Butterfly. Two that I will start will are: A Call Butterfly and a Put Butterfly.

A Call Butterfly spread is made up of a debit call spread and a credit call spread. Many times the reference to a debit call spread is made by using the different semantics such as long vertical call spread, whereas a credit call spread is also known as short vertical call spread. Some option traders label a short vertical call spread a Bear Call, while a long vertical call spread for them is a Bull Call. Regardless of the labels used, one should be aware of the fact that the Butterfly works the best in the sideway environment, as our aim is to profit from the time erosion.

Similar to a Call Butterfly spread, a Put Butterfly is made up of a debit put spread (Bear Put) and a credit put spread (Bull Put). Once again, some brokerage houses identify a debit put spread as a long vertical put spread and a credit put spread as a short vertical put spread.

The table below illustrates visually the Butterfly’s trading possibilities. These four examples exclude the Iron Butterfly, which will not be elaborated on in this newsletter.

Besides making this distinction by the trading transaction, I also must point out what is being bought and sold. The next table below shows the components of a Call Butterfly.

Generally, a call Butterfly is constructed by buying a lower strike price (Strike A) call, selling two calls at the middle strike price (Strike B), and buying one at the higher strike price (Strike C).

The structure of a Put Butterfly is almost identical, due to the fact that the only variation is the use of the puts. The figure below illustrates that visually, and it is easy to observe what the main difference is between Figure 2 and Figure 3.

The third distinction that ought to be made is about the distance between the strike prices. When the strike prices are exactly the same distance between each other (as in the case of Figure 3, Strike A is 47, Strike B is 46 and Strike C is 45), then no adjective is needed in front of the word Butterfly. The width of each spread is only one point; 47 to 46 is one point, and 46 to 45 is also one point. However, when the distance between the strike prices are not the same (Strike A is 48, Strike B is 46 and Strike C is 45), then the name for that type of Butterfly is a Broken-Wing Butterfly. The distance is two points between Strike A 48 and Strike B 46 on one end. Meanwhile the distance on the other end is only one point between the Strike B 46 and Strike C 45.

Additional clarification must be made in reference to what is the wing and what is NOT. The Strike A and Strike C are called the Wings, while the Strike B is called the Body.

In conclusion, in this newsletter article, I introduced the topic of Butterfly spread by focusing on the three main distinctions:

• By the options class (either a call Butterfly or a put Butterfly)
• By the transactions (long call Butterfly versus short call Butterfly)
• By the wing span (equidistant or normal Butterfly versus a broken-wing Butterfly)

In the following newsletters, I will give specific examples for different types of Butterflies. Have a green trading year.

- Josip Causic