What if a stock has run out of steam and we’re anticipating a period of consolidation or lower volatility for a period of time? What if we have identified a range-bound stock and we want to take advantage of this price pattern behavior? We can achieve this by trading low-risk, high-reward options strategies! The two strategies we’ll discuss in this chapter are the Butterfly and the Condor, both of which produce profits provided the price remains within a certain price range, determined by the Exercise prices we select.

Butterflies

The Butterfly involves the following steps (you can use all calls or all puts with the Butterfly—you cannot mix the two):

Butterfly with Calls

Step 1 Buy 1 lower strike (ITM) call

Step 2 Sell 2 middle strike ATM calls

Step 3 Buy 1 higher strike (OTM) call

There are two key points here:

  1. The ratio between buying the ITM call, selling the ATM calls, and buying the OTM call is 1:2:1.
  2. The distance between the three adjacent strikes must be equal, with the middle strike being ATM or as close to ATM as possible.

Butterfly with Puts

Step 1 Buy 1 lower strike (OTM) put

Step 2 Sell 2 middle strike ATM puts

Step 3 Buy 1 higher strike (ITM) put

There are two key points here:

  1. The ratio between buying the OTM put, selling the ATM puts and buying the ITM put is 1:2:1.
  2. The distance between the three adjacent strikes must be equal, with the middle strike being ATM or as close to ATM as possible.

The Butterfly will be a net debit transaction given that the ITM and OTM options you buy will be more expensive than the two ATM options you are selling to create the strategy spread. Remember in the real world you’ll be buying near the Ask and selling near the Bid, and even where you set a Limit Order (which you should do), you won’t have much chance of being filled by being over ambitious on the price of entry. Therefore, find an overall price that you’d be happy to make the trade at, having calculated and considered your Risk, Reward, and Breakeven scenarios.

FundsLong Call Butterfly

Buy lower strike call Sell 2 ATM calls

Buy higher strike call Long Call Butterfly

Long Put Butterfly

Buy lower strike put Sell 2 ATM puts Buy higher strike put Long Put Butterfly

The Risk Profile of a Butterfly is as follows, regardless of whether you use all calls or all puts:

Long Butterfly

Maximum risk: Limited to the net debit of the spread (what you pay)

Maximum reward: Limited to the difference between the adjacent strike prices less the net debit paid.

Breakeven on the downside: Lowest strike price plus net debit paid.

Breakeven on the upside: Highest strike price less net debit paid.

Maximum risk on net debit: 100% risk on net debit

As with Straddles and Strangles, the Butterfly has two breakeven scenarios, one to the downside and one to the upside. There the shared characteristics stop. The Butterfly can only yield a limited profit, and that can only occur at the middle Exercise price, the one nearest to the Money.

How To Find a Good Long Butterfly Opportunity and How To Play It

Key criteria:

  1. Rangebound stock pattern
  2. Implied Volatility and Historical Volatility
  3. Stock price

4. Timing

Again, we’ll look at each factor in isolation and then build a coherent methodology of finding and filtering for Long Butterfly trades.

i. (i) Rangebound Price Chart Pattern

We would like to find price patterns where we can identify clear lines of support and resistance to such a degree that we feel comfortable that the price will remain within those bounds. There is never a guarantee of such events materializing or not materializing, but ultimately we’re simply looking to reduce our risk wherever possible. Fortunately the Butterfly is an innately low-risk strategy in the first place, but we want to now increase our probability of success.

Wide Butterfly characteristics:

  1. Strikes A and C are wider apart. B is equidistant from them both.
  2. Greater Maximum Risk than with Narrow Butterfly.
  3. Lower Maximum Reward (as evidenced by height of B).
  4. Higher probability of profit (because a wider span above breakeven).

Narrow Butterfly

  1. Narrow Butterfly characteristics:
  2. Strikes A and C are closer together. B is still equidistant from them both.
  3. Lower Maximum Risk than with Wide Butterfly.
  4. Higher Maximum Reward (but less chance of achieving it).
  5. Lower probability of profit (because of the narrow span above breakeven).

So Step 1 is to find a price pattern with clear and distinguishable support and resistance. The wider the Butterfly, the less risky your trade will be in terms of probability of success, but the more risky it will be in terms of the net debit to pay for it.

ii. Implied Volatility and Historical Volatility

In a perfect Long Butterfly world, you’ll be looking for stocks that have experienced higher than their average Implied Volatility levels but where you expect the price action to calm down, leading to lower volatility levels for the duration of your trade.

This is easier said than done because even lowering volatility levels doesn’t necessarily help us with regard to the direction of price action, and the success of a Long Butterfly is dependent on price action remaining range-bound (and, depending on where you currently are within that range, price direction could be a vital factor). So be aware that before you start looking at volatility levels in this way, you must ensure you’re dealing with a price series with distinctive and strong support and resistance lines. Therefore, you should be looking at trades where the stock price is right in the middle of those support and resistance levels, equidistant from both. When this is the case, your lowest strike will be at or just below support, the highest strike price will be at or just above resistance, and the middle strike will be equidistant from them both and as close to ATM as possible.

iii. Stock Price

Again, it’s better to avoid the really low priced stocks (under $20) even though you’re concentrating here on price action keeping within a specific trading range. You want a wide enough wingspan on the Butterfly to improve your probability of profit, even if you’ll end up paying a bit more for it.

iv. Timing

As with all options trades, timing is crucial for Long Butterflies. Here are some rules for trading this strategy:

Entry

After you’ve identified your Long Butterfly stock, you need to make sure that there is no news coming soon. Ideally, all the news relating to that particular stock will have just passed, that is, earnings reports and any announcements concerning the stock or its sector. Furthermore, it’s best if some of the major government announcements, such as the CPI, PPI, GDP, Inflation Report have been made recently too. The idea here is that you do not want any surprises that might disturb the rangebound pattern of the stock.

Time to Expiration

The optimum timing for selecting expirations for your Long Butterfly is all about balance. Time Decay works in your favor because the longer you leave it, the more chance the price has of breaching one of your Long Butterfly’s wings. This leaves two potential dilemmas:

  1. If you choose an expiration date that is too close (under one month), you’ll be faced with a large net debit and hence risk because the only option of any real value will be the deep ITM option which you buy (either calls or puts).
  2. If you choose an expiration date that is too far away (more than two months), you’re increasing the probability that the price will breach one of the wings of the Butterfly and put you into a loss-making position.

I’ve found that the answer is to choose between one and two months for the optimal time frame for Long Butterflies. The reason is that it gives the ATM options (that you are selling as part of the spread) enough time to be of some value to reduce your net debit—and hence risk. At the same time, you’re not giving the position too much time to breach the wings of the Butterfly.

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