The Butterfly trade is one of the most versatile strategies available. Depending on your view of a particular share or index, you can place a Butterfly trade for either a sideways or directional move. A sideways trade normally requires you to sell two At the Money (ATM) options and then buy one In the Money (ITM) option and one Out of the Money (OTM) option to cover your risk.
Chart 1 below shows a Butterfly risk graph. Essentially you are combining a credit spread with a debit spread for a net debit, usually with a risk to reward ratio of 3:1 or better. Butterflies are best entered during times of higher than normal Implied Volatility to take advantage of the options increased premium that you get for the sold legs (the different positions that make up an options trade).
Chart 1 - Butterfly Risk Graph
click to enlarge
To trade them directionally you simply move the sold legs OTM to where you think the stock is heading. That is, if a stock is trading at say, $45 and you thought that it was going to $55 in 2 months then you could place an OTM Call butterfly by purchasing 1 x $50 Call selling 2 x $55 Calls and buying1 x $60 Call.
This is a limited risk trade. In this instance, the theory is that you want to control the $50 Call as cheaply as you can. Vice versa, if you thought that this $50 share was going down to $40 then you could do 45/40/35 Put Butterfly to control the $45 Put cheaply.
These types of trades can be entered for a much smaller debit than a vertical debit spread, but you will lose all your profit if the share travels too far past your anticipated price. As with every strategy, there are advantages and disadvantages.
These OTM trades can offer as much as 7:1 risk to reward, but they require the stock to be pretty much at your projected price, close to expiration to receive the maximum profit. In the above examples, all these Butterflies have the strikes an equal distance apart.
Another variation on the directional Butterfly is called the Broken Wing Butterfly. Chart 2 below shows a Broken Wing Butterfly risk graph. In this version you also take a directional view, but construct the trade in such a manner that all the risk is in one direction. This is achieved by having unequal distances between the strikes (split strikes).
If you thought the stock was going up then you would buy a slightly OTM Call, go 2 or even 3 strikes further out and sell 2 Calls and then go another1 strike up and buy another Call. In this instance you would be bringing in less credit but all your risk would be to the downside. The majority of profit would be at the short strike, but you would still continue to make a profit should the share rise past that point.
Chart 2 - Broken Wing Butterfly Risk Graph
click to enlarge
There are other versions which are called the Modified Fly, where you construct the trade using different bought and sold ratios. Instead of the traditional 1/2/1 construction you do a 1/3/2 or a 2/3/1 ratio depending on your view. These types of trades can become quite complex and require an even better understanding of the Greeks.
Many experienced traders often start off a trade with a straight Put or Call and then change it into a Butterfly to lock in a profit. This is not an article about when and how to trade the Butterfly strategy. It is to let you know that they exist and that they are worthwhile investigating.
Remember you always have options,