11/12/2013 Mon

Understanding the Basics of Butterfly Spreads: Part A

      In this topic butterfly spreads and variations will be addressed in an to attempt to build on a concept that will be further explained, after which the reader will have a fundamental grasp on the different ways to properly position themselves for a wide array of scenarios in regards to the underlying security in question.

      Butterfly spreads are an options position created by buying one vertical spread and selling another with the short strike of the verticals on the same underlying and on the same side, either puts or calls with the short strike of the verticals being the common strike. They are away to target a stock price regarding a specific range and are relatively low risk plays. In essence the short vertical, or vertical that is sold, is used to pay for apart of the cost of the long vertical, or vertical you purchase. They are considered low risk in that the cost is defined.

BRUN trading @ $55

The May 60/65/70 call butterfly may trade for .50 with 3 to 4 weeks left until May expiration at a nominal implied volatility of say 30 – 40 percent.

The position would read as long +1 May 60 call, short – 2 May 65 calls, and long + 1 May 70 call.

      The most you can lose would be .50 not including commissions. The potential for profit is 10 to 1 in that, if at or near expiration, BRUN were to trade around $65 at or near expiration the spread would be worth 5.00. A similar spread could be created through the use of put options with the May 50/45/40 strikes. The call butterfly would be considered bullish and the put butterfly bearish. Buying both creates a position that profits from a move either way, optimally, of 20% up or down. The further out from expiration you go the more you will pay for the spreads. You want to stay within a couple months of expiration due to the nature of options in regards to Theta, or time decay.

The full article as well as parts B and C can be viewed on tradersexclusive.com website

*Disclaimer: This is not a recommendation. All trading entails risk. Anyone employing any strategies and having limited knowledge of options trading should consult with a FINRA licensed professional.