Advanced Option Trading: The Modified Butterfly Spread (2024)

The majority of individuals who trade options start out simply buying calls and puts in order to leverage a market timing decision, or perhaps writing covered calls in an effort to generate income. Interestingly, the longer a trader stays in the options trading game, the more likely they are to migrate away from these two most basic strategies and to delve into strategies that offer unique opportunities.

One strategy that is quite popular among experienced options traders is known as the butterfly spread. This strategy allows a trader to enter into a trade with a high probability of profit, high-profit potential, and limited risk.

Key Takeaways

  • Butterfly spreads use four option contracts with the same expiration but three different strike prices spread evenly apart using a 1:2:1 ratio.
  • Butterfly spreads have caps on both potential profits and losses, and are generally low-risk strategies.
  • Modified butterflies use a 1:3:2 ratio to create a bullish or bearish strategy that has greater risk, but a higher potential reward, than a standard butterfly

The Basic Butterfly Spread

Before looking at the modified version of the butterfly spread, let's do a quick review of the basic butterfly spread. The basic butterfly can be entered using calls or puts in a ratio of 1 by 2 by 1. This means that if a trader is using calls, they will buy one call at a particular strike price, sell two calls with a higher strike price and buy one more call with an even higher strike price. When using puts, a trader buys one put at a particular strike price, sells two puts at a lower strike price, and buys one more put at an even lower strike price. Typically the strike price of the option sold is close to the actual price of the underlying security, with the other strikes above and below the current price. This creates a "neutral" trade whereby the trader makes money if the underlying security remains within a particular price range above and below the current price. However, the basic butterfly can also be used as a directional trade by making two or more of the strike prices well beyond the current price of the underlying security.

Figure 1 displays the risk curves for a standard at-the-money, or neutral, butterfly spread. Figure 2 displays the risk curves for an out-of-the-money butterfly spread using call options.

Advanced Option Trading: The Modified Butterfly Spread (1)

Source: Optionetics Platinum

Source: Optionetics Platinum

Both of the standard butterfly trades shown in Figures 1 and 2 enjoy a relatively low and fixed-dollar risk, a wide range of profit potential, and the possibility of a high rate of return.

The Modified Butterfly

The modified butterfly spread is different from the basic butterfly spread in several important ways:

  1. Puts are traded to create a bullish trade and calls are traded to create a bearish trade.
  2. The options are not traded in 1:2:1 fashionbut rather in a ratio of 1:3:2.
  3. Unlike a basic butterfly that has two breakeven prices and a range of profit potential, the modified butterfly has only one breakeven price, which is typically out-of-the-money. This creates a cushion for the trader.
  4. One negative associated with the modified butterfly versus the standard butterfly: While the standard butterfly spread almost invariably involves a favorable reward-to-risk ratio, the modified butterfly spread almost invariably incurs a great dollar risk compared to the maximum profit potential. Of course, the one caveat here is that if a modified butterfly spread is entered properly, the underlying security would have to move a great distance in order to reach the area of maximum possible loss. This gives alert traders a lot of room to act before the worst-case scenario unfolds.

Figure 3 displays the risk curves for a modified butterfly spread. The underlying security is trading at $194.34 a share. This trade involves:

  • Buying one 195 strike price put
  • Selling three 190 strike price puts
  • Buying two 175 strike price puts

Advanced Option Trading: The Modified Butterfly Spread (3)

Source: Optionetics Platinum

A good rule of thumb is to enter a modified butterfly four to six weeks prior to option expiration. As such, each of the options in this example has 42 days (or six weeks) left until expiration.

Note the unique construction of this trade. One at-the-money put (195 strike price) is purchased, three puts are sold at a strike price that is five points lower (190 strike price) and two more puts are bought at a strike price 20 points lower (175 strike price).

There are several key things to note about this trade:

  1. The current price of the underlying stock is 194.34.
  2. The breakeven price is 184.91. In other words, there are 9.57 points (4.9%) of downside protection. As long as the underlying security does anything besides declining by 4.9% or more, this trade will show a profit.
  3. The maximum risk is $1,982. This also represents the amount of capital that a trader would need to put up to enter the trade. Fortunately, this size of loss would only be realized if the trader held this position until expiration and the underlying stock was trading at $175 a share or less at that time.
  4. The maximum profit potential for this trade is $1,018. If achieved this would represent a return of 51% on the investment. Realistically, the only way to achieve this level of profit would be if the underlying security closed at exactly $190 a share on the day of option expiration.
  5. The profit potential is $518 at any stock price above $195—26% in six weeks' time.

Key Criteria to Consider in Selecting a Modified Butterfly Spread

The three key criteria to look at when considering a modified butterfly spread are:

  1. Maximum dollar risk
  2. Expected percentage return on investment
  3. Probability of profit

Unfortunately, there is no optimum formula for weaving these three key criteria together, so some interpretation on the part of the trader is invariably involved. Some may prefer a higher potential rate of return while others may place more emphasis on the probability of profit. Also, different traders have different levels of risk tolerance. Likewise, traders with larger accounts are better able to accept trades with a higher maximum potential loss than traders with smaller accounts.

Each potential trade will have its own unique set of reward-to-risk criteria. For example, a trader considering two possible trades might find that one trade has a probability of profit of 60% and an expected return of 25%, while the other might have a probability of profit of 80% but an expected return of only 12%. In this case, the trader must decide whether they put more emphasis on the potential return or the likelihood of profit. Also, if one trade has a much greater maximum risk/capital requirement than the other, this too must be taken into account.

The Bottom Line

Options offer traders a great deal of flexibility to craft a position with unique reward-to-risk characteristics. The modified butterfly spread fits into this realm. Alert traders who know what to look for and who are willing and able to act to adjust a trade or cut a loss if the need arises, may be able to find many high probability modified butterfly possibilities.

Advanced Option Trading: The Modified Butterfly Spread (2024)

FAQs

What is the success rate of the butterfly strategy? ›

It may generate a stable income and reduce the risks as much as possible compared with directional spreads, using very little capital. What is the success rate of the iron butterfly strategy? There is a 20% to 30% probability of an iron butterfly achieving any profit. It makes an entire profit only 23% of the time.

What is the modified butterfly spread? ›

The modified butterfly spread is different from the basic butterfly spread in several important ways: Puts are traded to create a bullish trade and calls are traded to create a bearish trade. The options are not traded in 1:2:1 fashion but rather in a ratio of 1:3:2.

How to profit from butterfly spread? ›

Long Call Butterfly Spread

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.

Which option strategy has the highest success rate? ›

A Bull Call Spread is made by purchasing one call option and concurrently selling another call option with a lower cost and a higher strike price, both of which have the same expiration date. Furthermore, this is considered the best option selling strategy.

What is the most consistently profitable option strategy? ›

The most successful options strategy for consistent income generation is the covered call strategy. An investor sells call options against shares of a stock already owned in their portfolio with covered calls. This allows them to collect premium income while holding the underlying investment.

How accurate is the butterfly effect? ›

Although small things can have a large impact, it is difficult, if not impossible, to accurately predict the relationship between small actions and effects. As we have mentioned, the butterfly effect does not mean that small things will necessarily lead to large consequences, but that they equally could or could not.

When to use butterfly spread? ›

This means that the price of a long butterfly spread falls when volatility rises (and the spread loses money). When volatility falls, the price of a long butterfly spread rises (and the spread makes money). Long butterfly spreads, therefore, should be purchased when volatility is “high” and forecast to decline.

What is the payoff diagram of a butterfly spread? ›

Call Butterfly payoff diagram

The payoff diagram of a long call butterfly defines the maximum risk and reward. The maximum loss on the trade is defined at entry by the combined cost of the four call options and is realized if the underlying stock price closes above or below the long options at expiration.

What is an example of a butterfly spread strategy? ›

Example: Long call butterfly spread

Suppose an investor believes that the stock of XYZ company, currently trading at Rs. 55, will remain relatively stable over the next month. To profit from this expectation, they can employ a call butterfly spread as follows: Buy one call option with a strike price of Rs.

What is butterfly spread for dummies? ›

From a basic standpoint, a butterfly spread involves buying call options at a specific strike price, while simultaneously selling call options at both a higher and lower strike price.

What are the advantages of butterfly spreads? ›

Limited risk: One of the primary advantages of butterfly spreads is that they offer a limited risk to the trader. This is because the maximum loss is limited to the net premium paid for the position.

What is a 1 3 2 option strategy? ›

In its simplest state, a 1-3-2 trade is a long call (or put) butterfly with a sale of a call (or put) spread inside the butterfly. The sale of the call (or put) vertical is done to receive a credit to pay for the butterfly spread. A more detailed discussion of this strategy can be found in the Practicals HomeStudy Kit.

How do you never lose in option trading? ›

The option sellers stand a greater risk of losses when there is heavy movement in the market. So, if you have sold options, then always try to hedge your position to avoid such losses. For example, if you have sold at the money calls/puts, then try to buy far out of the money calls/puts to hedge your position.

What is the most profitable trading strategy of all time? ›

Three most profitable Forex trading strategies
  1. Scalping strategy “Bali” This strategy is quite popular, at least, you can find its description on many trading websites. ...
  2. Candlestick strategy “Fight the tiger” ...
  3. “Profit Parabolic” trading strategy based on a Moving Average.
Jan 19, 2024

What option makes the most money? ›

Deciding what career to pursue can be a tricky decision when you're first starting out.
  • General internal medicine physician.
  • Family medicine physician.
  • Orthodontist.
  • Nurse anesthetist.
  • Pediatrician (general)
  • Dentist.
  • Computer and information systems manager.
  • Architectural and engineering manager.
Mar 1, 2024

What is the probability of option butterfly? ›

In finance, a butterfly (or simply fly) is a limited risk, non-directional options strategy that is designed to have a high probability of earning a limited profit when the future volatility of the underlying asset is expected to be lower (when long the butterfly) or higher (when short the butterfly) than that asset's ...

How much have butterflies declined? ›

More alarmingly, the western population that winters in California has collapsed by nearly 99.4 percent, and could disappear in a few short years. The monarch butterfly has been decreasing towards extinction due to landscape-scale threats from pesticides, development and global climate change.

How butterfly effect can lead to success? ›

The butterfly effect can have a profound impact on overall team morale. Positive individual actions, even small ones, can boost employee engagement and satisfaction, leading to improved productivity and a healthier work environment.

Are butterflies effective? ›

They pollinate plants in your garden

Butterflies are great for your garden as they are attracted to bright flowers and need to feed on nectar. When they do this their bodies collect pollen and carry it to other plants. This helps fruits, vegetables and flowers to produce new seeds.

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