Options are amazing investing and trading tools. While one can use options to position for a move up or a move down in the price of a commodity or any asset, options also have other purposes. Since the chief determinant of the price of an option is implied volatility, call and put option prices respond to changes in market volatility as well as price.
Spreading options is the process of trading one or more options against others. Option spreads are often volatility spreads. They are a bet on increasing or decreasing volatility. Long option spreads generally have limited risk while short option spreads have unlimited potential losses. One spread that option traders often use is the butterfly spread.
The Butterfly Spread
The butterfly spread is a neutral strategy that is a combination of a bull spread and a bear spread. There are three strike prices involved in a butterfly spread. These spreads have limited risk and can involve call or put options. A long call butterfly spread is a trade used by an investor who does not think the price of an asset will move far from its current price. This trade involves selling two call options that are close to or at the current market price and buying one call option that is in the money and one call option that is out of the money.
A long put butterfly spread is another type of option spread that results in a position for an investor who does not think the price of an asset will move far from its current price. This trade involved selling two put options that are close to or at the current market price and buying one in the money and one out of the money put option.
In both cases, the maximum profit at expiration occurs at the strike price of the short or sold options. The maximum loss occurs above or below the strike prices of the options bought. The formula for maximum loss for the long call butterfly is as follows:
Maximum Profit = Strike price of short call options - Strike price of lower strike long call option - premium plus commissions paid for the trade at inception
The maximum profit occurs when the price of the underlying (at expiration) equals the strike price of the short call options.
The breakeven point for the long call butterfly can occur at two prices at expiration:
- Upper breakeven point = Strike price of the higher long call - net premium and commissions paid
- Lower breakeven point = Strike price of the lower long call option + net premium and commissions paid
The Put Butterfly
The long call or put butterfly is usually a debit spread, meaning the net of the premiums results in a payable for the spread. The short call or put butterfly is usually a credit spread -- the trader or investor selling the butterfly receives the premium. Those who sell these butterfly trades are positioning for a move above or below the upper or lower end of the strike prices for the asset at expiration.
Therefore, a long butterfly trade is a bet that volatility will decrease or prices will remain the same while a short butterfly trade is a bet that volatility will increase or prices will move outside the range of strike prices of the butterfly spread. In the world of options, the potential of volatility is a probability game, the chance of a huge move is always less than the chance of stability.
That is why the buyer of the butterfly usually pays for the spread and the seller receives the premium.
Butterfly option spreads are popular with professional traders. In the world of commodities, some prices are more volatile than others are. For example, gold tends to be less volatile than crude oil, natural gas, or sugar.
However, all of the futures markets in these commodities offer call and put option contracts. Constructing butterfly option spreads is one way of taking a view on the volatility or price variance for these markets over a particular period. Those who expect a stable market would favor the long butterfly, while those looking for a big move would favor the short side on these spreads.