Short Butterfly Explained

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Long Butterfly Spread w/Puts

The Strategy

A long put butterfly spread is a combination of a short put spread and a long put spread, with the spreads converging at strike B.

Ideally, you want the puts with strikes A and B to expire worthless, while capturing the intrinsic value of the in-the-money put with strike C.

Because you’re selling two options with strike B, butterflies are a relatively low-cost strategy. So the risk vs. reward can be tempting. However, the odds of hitting the sweet spot are fairly low.

Constructing your butterfly spread with strike B slightly in-the-money or slightly out-of-the-money may make it a bit less expensive to run. This will put a directional bias on the trade. If strike B is higher than the stock price, this would be considered a bullish trade. If strike B is below the stock price, it would be a bearish trade. (But for simplicity’s sake, if bullish, calls would usually be used to construct the spread.)

Options Guy’s Tip

Some investors may wish to run this strategy using index options rather than options on individual stocks. That’s because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index’s component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.

The Setup

  • Buy a put, strike price A
  • Sell two puts, strike price B
  • Buy a put, strike price C
  • Generally, the stock will be at strike B

NOTE: Strike prices are equidistant, and all options have the same expiration month.

Who Should Run It

Seasoned Veterans and higher

NOTE: Due to the narrow sweet spot and the fact you’re trading three different options in one strategy, butterfly spreads may be better suited for more advanced option traders.

When to Run It

Typically, investors will use butterfly spreads when anticipating minimal movement on the stock within a specific time frame.

Break-even at Expiration

There are two break-even points for this play:

  • Strike A plus the net debit paid.
  • Strike C minus the net debit paid.

The Sweet Spot

You want the stock price to be exactly at strike B at expiration.

Maximum Potential Profit

Potential profit is limited to strike C minus strike B minus the net debit paid.

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Maximum Potential Loss

Risk is limited to the net debit paid.

Ally Invest Margin Requirement

After the trade is paid for, no additional margin is required.

As Time Goes By

For this strategy, time decay is your friend. Ideally, you want all options except the put with strike C to expire worthless with the stock precisely at strike B.

Implied Volatility

After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.

If your forecast was correct and the stock price is at or around strike B, you want volatility to decrease. Your main concern is the two options you sold at strike B. A decrease in implied volatility will cause those near-the-money options to decrease in value, thereby increasing the overall value of the butterfly. In addition, you want the stock price to remain stable around strike B, and a decrease in implied volatility suggests that may be the case.

If your forecast was incorrect and the stock price is approaching or outside of strike A or C, in general you want volatility to increase, especially as expiration approaches. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike B, thereby increasing the overall value of the butterfly.

Check your strategy with Ally Invest tools

  • Use the Profit + Loss Calculator to establish break-even points, evaluate how your strategy might change as expiration approaches, and analyze the Option Greeks.

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What Exactly Is The Butterfly Effect?

Is The Butterfly Effect a real thing? The answer might surprise you.

Whilst Butterfly wings can be used to do some amazing things, do they really have the power to change the weather? The answer might surprise you.

Chaos is about to ensue so hold on tight.

What is the Butterfly Effect simple explanation?

One of the best ways to understand a complex idea is to make an easy-to-understand metaphor. In the case of Chaos Theory, the term “The Butterfly Effect” was created to attempt just such a thing.

The metaphor goes:

“Does the flap of a butterfly’s wings in Brazil set off a tornado in Texas?”

It isn’t meant to imply that this could actually happen, just that a small event, like this, at the right time and place could, in theory, trigger a set of events that will ultimately culminate in the formation of a hurricane on the other side of the world.

This was coined by one Edward Lorenz almost 45 years ago during the 139th meeting of the Association for the Advancement of Science. It would prove to be very popular and has been embraced by popular culture ever since.

Lorenz was a meteorology professor at MIT. He developed the concept but never actually intended for it to be applied the way it has all too commonly been used.

Whilst it sounds a little ridiculous as a concept, it is not meant to be taken literally. “The Butterfly Effect” metaphor is simply meant to demonstrate that little insignificant events can lead to significant results over time.

To put it another way, small variances in initial conditions can have profound and widely divergent effects on a system. Such chaotic systems are unpredictable by their very nature.

This idea became the basis for a branch of mathematics known as Chaos Theory , which has been applied in countless scenarios since its introduction.

This branch of mathematics has come to question some fundamental laws of physics. Particularly those proposed by Sir Isaac Newton about the mechanical and predictable nature of the Universe.

Similarly, Lorenz challenged Pierre-Simon Laplace, who argued that unpredictability has no place in the universe, asserting that if we knew all the physical laws of nature, then “nothing would be uncertain and the future, as the past, would be present to [our] eyes.”

Lorenz was quick to point out one of the main problems we have is the imprecise nature of our measurement devices for things like physical phenomena. All we can ever hope to do, therefore, is make an educated best guess or approximation of events.

This is especially true for highly complex systems like weather patterns. Whilst theories in other fields of science, like physics, try to model nature, in real life they are complex systems.

Most things in nature tend to be the result of many interconnected, and interdependent, cause-and-effect relationships. This means they are staggeringly complex and probably impossible to ever resolve adequately in practice.

What is The Butterfly Effect for dummies?

The first thing to understand is that “The Butterfly Effect” is just a metaphor for a field of mathematics called Chaos Theory.

Chaos Theory is, in effect, the science of surprises, the nonlinear and the unpredictable. The theory teaches anyone who learns it that we should come to expect the unexpected.

In this sense, it stands in direct contrast with most other fields of science that tend to deal with predictable patterns to provide accurate predictions of things.

After all, replicability and reliability of the scientific principle are one of its foundations. Fundamental things like gravity, electricity, and chemical reactions being prime examples.

Chaos Theory, in this case, asks us to throw the idea of being able to predict things with any real confidence out of the window – at least for highly complex systems. It deals with the nonlinear that are, by their very nature, impossible to predict or control with any real certainty.

It is simply too impractical to ever know every data point in a system with perfect precision. Plus we cannot go back to the very beginning of time to record and track every data point.

We simply can’t know everything or even ever hope to.

In essence, we can only ever make a best guess approximation of such things. We can never be 100% correct as even small starting differences could throw the result off widely as the errors of any model, equation or algorithm, will accumulate over time.

Turbulence, weather, and even the Stock Market are such systems.

“As far as the laws of mathematics refer to reality, they are not certain, and as far as they are certain, they do not refer to reality.” – Albert Einstein

Many natural objects also tend to show the results of the complex interactions that led to their creation. Things like landscapes, clouds, trees, and river systems exhibit something called fractal properties.

Fractals are never-ending patterns that tend to be infinitely complex that also tend to be self-similar at different scales. They are created by repeating a simple process over and over again in a feedback loop.

Driven by recursion, fractals are images of dynamic systems – the pictures of Chaos. If you look closely at nature you will quickly come to see that it is a very common phenomenon.

By understanding that our ecosystems, our social systems, and our economic systems are interconnected, we can hope to avoid actions which may end up being detrimental to our long-term well-being.

What is the origin of “The Butterfly Effect”?

The Butterfly Effect” is not a thing in and of itself. It is just a metaphor for the principle of Chaos Theory.

More technically, it is the ” sensitive dependence on initial conditions”.

The term is often ascribed to Edward Lorenz who wrote about it in a 1963 paper in the New York Academy of Sciences. But with a subtle difference:

“One meteorologist remarked that if the theory were correct, one flap of a seagull’s wings would be enough to alter the course of the weather forever.”

By the time of his now infamous talk at the 1972 American Association for the Advancement of Science in Washington, D.C. By this time the seagull had been replaced with the now iconic butterfly.

The entire principle was born out of the shock Lorenz had when trying to run some weather models using deterministic equations on a supercomputer.

In theory, it should be fairly straight forward to input measurable factors like temperature, pressure and wind velocity and have a supercomputer do some number crunching to predict the weather in the future.

He input an initial set of data, switched the computer on, and waited for the printout. Placing the output next to the machine, he decided to re-enter some of the data and run the program longer.

But the results were widely different for the two. He soon realized he’d made a very minor error during input on the second run which yielded a drastically different outcome.

He had entered the initial condition 0.506 from the printout instead of entering the full precision 0.506127 value.

Lorenz had an epiphany, and a whole new field of mathematics was born – Chaos Theory.

Lorenz died in 2008, and it’s clear that his enduring contribution to our understanding of complex systems was an important one.

Опционная стратегия Butterfly (бабочка)

Создание. Комбинация состоит из продажи двух опционов Call на деньгах, покупка одного Call опциона в деньгах и покупка опциона Call без денег (OTM).

Убыток ограничен ценой опциона на деньгах минус цена страйк опциона в деньгах минус чистая премия, уплаченная за спред.

Прибыль ограничена полученной премией.

Используется, когда по базовому активу активных движений не ожидается и прогнозируется снижение волатильности.

Опционная стратегия Long Call Butterfly схожа со стратегией Short Straddle за исключением того, что убытки ограничены. Разница между покупкой бабочки и продажей стрэддла – премия. За покупку бабочки нужно будет уплатить премию, в то время как продажа стрэддла ничего не будет стоить, так как будет получена премия.

Long Put Butterfly

Создание. Продажа двух опционов Put на деньгах, покупка одного Put опциона в деньгах и покупка одного Put опциона без денег. Эта стратегия идентична стратегии Long Call Butterfly за исключением того, что здесь используются опционы пут вместо кол опционов.

Short (Call) Put Butterfly

Создание. Покупка двух Put опционов на деньгах, продажа одного Put опциона в деньгах и продажа одного Put опциона без денег.

Максимальный убыток ограничен разницей цен исполнения опционов на деньгах минус цена опциона в деньгах минус итоговая премия, которая была получена.

Прибыль ограничена премией, полученной за опционный спрэд

Используется, когда ожидается движение в какую-либо сторону: вниз или вверх, а также ожидается рост волатильности.

Продажа бабочки пут имеет те же характеристики, что и продажа бабочки кол – единственная разница состоит в том, что здесь используются пут опционы вместо опционов кол.

Butterfly Spread

What Is a Butterfly Spread?

A butterfly spread is an options strategy combining bull and bear spreads, with a fixed risk and capped profit. These spreads, involving either four calls or four puts are intended as a market-neutral strategy and pay off the most if the underlying does not move prior to option expiration.

Key Takeaways

  • There are multiple butterfly spreads, all using four options.
  • All butterfly spreads use three different strike prices.
  • The upper and lower strike prices are equal distance from the middle, or at-the-money, strike price.
  • Each type of butterfly has a maximum profit and a maximum loss.

Understanding Butterflies

Butterfly spreads use four option contracts with the same expiration but three different strike prices. A higher strike price, an at-the-money strike price, and a lower strike price. The options with the higher and lower strike prices are the same distance from the at-the-money options. If the at-the-money options have a strike price of $60, the upper and lower options should have strike prices equal dollar amounts above and below $60. At $55 and $65, for example, as these strikes are both $5 away from $60.

Puts or calls can be used for a butterfly spread. Combining the options in various ways will create different types of butterfly spreads, each designed to either profit from volatility or low volatility.

Long Call Butterfly

The long butterfly call spread is created by buying one in-the-money call option with a low strike price, writing two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. Net debt is created when entering the trade.

The maximum profit is achieved if the price of the underlying at expiration is the same as the written calls. The max profit is equal to the strike of the written option, less the strike of the lower call, premiums, and commissions paid. The maximum loss is the initial cost of the premiums paid, plus commissions.

Short Call Butterfly

The short butterfly spread is created by selling one in-the-money call option with a lower strike price, buying two at-the-money call options, and selling an out-of-the-money call option at a higher strike price. A net credit is created when entering the position. This position maximizes its profit if the price of the underlying is above or the upper strike or below the lower strike at expiry.

The maximum profit is equal to the initial premium received, less the price of commissions. The maximum loss is the strike price of the bought call minus the lower strike price, less the premiums received.

Long Put Butterfly

The long put butterfly spread is created by buying one put with a lower strike price, selling two at-the-money puts, and buying a put with a higher strike price. Net debt is created when entering the position. Like the long call butterfly, this position has a maximum profit when the underlying stays at the strike price of the middle options.

The maximum profit is equal to the higher strike price minus the strike of the sold put, less the premium paid. The maximum loss of the trade is limited to the initial premiums and commissions paid.

Short Put Butterfly

The short put butterfly spread is created by writing one out-of-the-money put option with a low strike price, buying two at-the-money puts, and writing an in-the-money put option at a higher strike price. This strategy realizes its maximum profit if the price of the underlying is above the upper strike or below the lower strike price at expiration.

The maximum profit for the strategy is the premiums received. The maximum loss is the higher strike price minus the strike of the bought put, less the premiums received.

Iron Butterfly

The iron butterfly spread is created by buying an out-of-the-money put option with a lower strike price, writing an at-the-money put option, writing an at-the-money call option, and buying an out-of-the-money call option with a higher strike price. The result is a trade with a net credit that’s best suited for lower volatility scenarios. The maximum profit occurs if the underlying stays at the middle strike price.

The maximum profit is the premiums received. The maximum loss is the strike price of the bought call minus the strike price of the written call, less the premiums received.

Reverse Iron Butterfly

The reverse iron butterfly spread is created by writing an out-of-the-money put at a lower strike price, buying an at-the-money put, buying an at-the-money call, and writing an out-of-the-money call at a higher strike price. This creates a net debit trade that’s best suited for high-volatility scenarios. Maximum profit occurs when the price of the underlying moves above or below the upper or lower strike prices.

The strategy’s risk is limited to the premium paid to attain the position. The maximum profit is the strike price of the written call minus the strike of the bought call, less the premiums paid.

Example of a Long Call Butterfly

An investor believes that Verizon stock, currently trading at $60 will not move significantly over the next several months. They choose to implement a long call butterfly spread to potentially profit if the price stays where it is.

An investor writes two call options on Verizon at a strike price of $60, and also buys two additional calls at $55 and $65.

In this scenario, an investor would make the maximum profit if Verizon stock is priced at $60 at expiration. If Verizon is below $55 at expiration, or above $65, the investor would realize their maximum loss, which would be the cost of buying the two wing call options (the higher and lower strike) reduced by the proceeds of selling the two middle strike options.

If the underlying asset is priced between $55 and $65, a loss or profit may occur. The amount of premium paid to enter the position is key. Assume that it costs $2.50 to enter the position. Based on that, if Verizon is priced anywhere below $60 minus $2.50, the position would experience a loss. The same holds true if the underlying asset were priced at $60 plus $2.50 at expiration. In this scenario, the position would profit if the underlying asset is priced anywhere between $57.50 and $62.50 at expiration.

This scenario does not include the cost of commissions, which can add up when trading multiple options.

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