A butterfly is a defined risk option strategy that is best utilized when you think a stock will reach and settle at a certain price (either higher, lower, or unchanged). It is executed by buying a lower strike option, selling to middle strike options (where you think the stock price will settle), and buying one higher strike option. For example, if you had a slight bullish bias on CSCO but didn’t think the Company would bounce back strongly by January 2012 expiration, you could long a 16 Call, short two 17.50 Calls and long a 19 Call. With 216 days to expiration and an implied volatility of 29%-30%, you can purchase this butterfly for .17.
The maximum risk for the butterfly is losing the entire debit that you paid for it (.17). The trade would be profitable if CSCO is between 16.17 and 18.83 at expiration. The maximum profitability would be achieved if the stock rises to the short strike of 17.50 at expiration (1.33). On the face of it, the butterfly looks like a great trade; you only risk .17 to make a potential 1.33. However, the probability of the stock ending up between our long strikes of 16 and 19 is only 21.50%; furthermore, the probability of maximizing your profit when the stock gets pinned to your short position is even less likely.
Improving Your Odds
It is possible to improve the probability of success if you add some directional risk to the trade. The best way to do this would be to combine a higher probability directional trade with the butterfly. A short vertical is the most popular addition and enhances what we like about the butterfly: defined risk and positive time decay (selling theta!, the standard butterfly may or may not have positive time decay depending on the price of the underlying and the strikes of the butterfly), but also adds a broader range for profitability and a higher probability of success. In aggregate, the standard butterfly that we looked at before has become an unbalanced butterfly.
In the CSCO example discussed above, this could be achieved by selling the 19/20 call vertical for .09.
Now we are holding long a 16/17.5/19 call butterfly and short a 19/20 call vertical. On a consolidated basis, we are long a 16 call, short two 17.5 calls, have no position in the 19 call (the long and short position cancel each other out), and long a 20 call.
Our profitability profile has changed slightly and now we have a slightly higher probably of success (albeit with materially more risk, our .17 risk has increased to 1.08) and increased our returns (or reduced our losses) in all scenarios where CSCO is below 19 at the January 2012 expiration (P&L graph below).
Position Management & Suitability
The risk exposure of this position is not for everyone. But in exchange for the greater risk that you are willing to take on two things have happened. First, you get a higher maximum profit and second, you maintain minimal risk (in this case .08 per trade, often times you can put on an unbalanced butterfly for a credit) on a downside move in the underlying.
The unbalanced butterfly is most attractive in two situations. Frist this position is most popular to those that are net long in the market. For example, if CSCO were to rally past the high price breakeven point (18.92) it is likely that the entire market is rallying as well and gains in other positions in your portfolio would offset the losses that would occur between 18.92 and 20. Another situation where this trade would be attractive is when you are already long the underlying and want to increase you exposure with no or minimal outlay of capital. This is attractive because between your two short 17.5 calls and long 20 call, that negative exposure is hedge by the long stock position. See the P&L graph below.
I am a fan of both the balanced and unbalanced butterfly, but finding the right set ups and selecting the right strikes are the most challenging part of putting on the trade. I view this trade is a good arrow to have in your quiver, and even though it is unlikely that you will find yourself reaching for it very often it might just fit the expectations you have for a company and be the perfect trade to put on.