How Does The Bull Butterfly Spread Work in Options Trading?
Bull Butterfly Spread - Introduction
The Bull Butterfly Spread is a complex bullish options strategy with limited profit and limited loss. It makes its maximum profit when the underlying stock rises to a pre-determined higher price. Like a normal butterfly spread, the Bull Butterfly Spread can be constructed using only call options, known as the Bull Call Butterfly Spread, or only put options, known as the Bull Put Butterfly Spread. The Bull Butterfly Spread is really just a normal butterfly spread using a higher middle strike price, effectively moving the maximum profit point up to a higher strike price.
The Bull Butterfly Spread also has the highest Return on Investment of all the complex bullish options trading strategies due to its extremely low capital requirement.
Find Options Strategies With Similar Risk Profiles
|
Comparing The Bull Butterfly Spread
So, how does the Bull Butterfly Spread compare against the other two most popular complex bullish options strategies, the Bull Call Spread and the Bull Put Spread? Is the Bull Butterfly Spread worth the time and effort learning? We decided to compare the Maximum Profit, the Capital Outlay and the resultant Return on Investment to see if the Bull Butterfly Spread is worth using at all.
|
QQQQ options chain on 9 July 2010. QQQQ trading at $44.20.
Aug44Call = $1.65 , Aug45Call = $1.11 , Aug46Call = $0.68 , Aug47Call = $0.40 Aug44Put = $1.44 , Aug45Put = $1.90 , Aug46Put = $2.47 , Aug47Put = $3.17 |
|||
| Strategy | Max Net Profit @ $46 | Capital Outlay (Max Loss) | ROI |
| Bull Butterfly Spread* | $85 | $15 | 560% |
| Bull Call Spread | $103 | $97 | 106% |
| Bull Put Spread | $103 | $97** | 106% |
** : Maximum loss used as it is a credit spread
As you can see above, if you expect the underlying stock to hit a certain definite strike price (and not beyond that strike price) by expiration, the Bull Butterfly Spread would return a far higher return on investment than all the other complex bullish options strategies. However, it must be noted that the Bull Butterfly Spread makes its maximum profit only when the underlying stock closes exactly at the strike price of the middle strike upon expiration. If the price of the underlying stock moves way beyond the strike price of the middle strike, the position could make a lot lesser profit and may even go into a loss. As such, the high ROI of a Bull Butterfly Spread rewards the precision of your prediction on the movement of the underlying stock. Indeed, options trading is fair and higher ROI rewards greater precision or compromises in other areas.
When To Use Bull Butterfly Spread?
One should use a Bull Butterfly Spread when one expects the price of the underlying stock to move up to but not exceeding a certain strike price by options expiration.
How To Use Bull Butterfly Spread?
There are two ways to establish a Bull Butterfly Spread. One way is to use only call options. We call this a "Bull Call Butterfly Spread". The other way is to
use only put options. We call that a "Bull Put Butterfly Spread". Either way uses the same strike prices and typically cost almost the same capital outlay, returning almost the same profit.
Buy 1 Lower Strike + Sell 2 @ Expected Strike + Buy 1 Higher Strike
Establishing Bull Call Butterfly Spread
Veteran or experienced option traders would identify at this point that the Bull Call Butterfly Spread actually consists of an OTM Bull
Call Spread and an OTM Bear Call Spread.
The choice of middle strike price is simply the price which you expect the underlying stock to close at by expiration of the position. The more accurate your prediction is, the greater the chance of hitting maximum profit.
|
Bull Call Butterfly Spread Example
Using the data from the comparison example above Sell To Open 2 contracts of Aug $46 Call at $0.68 Buy To Open 1 contract of Aug $47 Call at $0.40 Net Debit = ($1.11 - $0.68 - $0.68 + $0.40) x 100 = $15.00 per position |
In the above Call Bull Butterfly Spread example, we are expecting the QQQQ to reach $46 on August expiration.
Establishing Bull Put Butterfly Spread
Establishing a Bull Put Butterfly Spread is exactly the same as establishing a Bull Call Butterfly Spread except that put options are used instead. Strike prices used are exactly the same. The resultant net debit and maximum of a Bull Put Butterfly Spread is theoretically the same as you would use call options, however, in practical options trading, sometimes Call options and Put options do not cost the same to put on. In stocks that are likely to be more bullish, its call options will be more expensive than its put options and vice versa. Therefore, an options trader needs to calculate whether a Bull Call Butterfly Spread or a Bull Put Butterfly Spread makes more sense in the prevailing circumstances.
|
Bull Put Butterfly Spread Example
Using the data from the comparison example above Sell To Open 2 contracts of Aug $46 Put at $2.47 Buy To Open 1 contract of Aug $47 Put at $3.17 Net Debit = ($1.90 - $2.47 - $2.47 + $3.17) x 100 = $13.00 per position |
In this case, Bull Put Butterfly Spread requires a slightly lower net debit than the Bull Call Butterfly Spread, so the Bull Put Butterfly Spread should be used instead.
Trading Level Required For Bull Butterfly Spread
A Level 3 options trading account that allows the execution of debit spreads is needed for the Bull Butterfly Spread. Read more about Options Account Trading Levels.
Profit Potential of Bull Butterfly Spread :
Bull Butterfly Spreads achieve their maximum profit potential when the underlying stock closes exactly on the middle strike price by expiration. The profitability of a Bull Butterfly Spread can also be enhanced or better guaranteed by legging into the position properly.
Profit Calculation of Bull Butterfly Spread:
Maximum Profit = Strike Difference between Long and Short leg - debit
Maximum Loss = Net Debit
|
From the above Bull Put Butterfly Spread example :
Maximum Profit = [($46 - $45) - 0.13] x 100 = $87 Maximum Loss = $13 |
Risk / Reward of Bull Butterfly Spread:
Upside Maximum Profit: Limited
Maximum Loss: Limited
Break Even Points of Bull Butterfly Spread:
A Bull Butterfly Spread is profitable if the price of the underlying stock remains between the higher and lower breakeven point.
1. Lower Breakeven Point : Lower Strike Price + Debit
|
From the above Bull Put Butterfly Spread example :
Debit = $0.13 , Lower Strike Price = $45.00 Lower Breakeven Point = $45 + $0.13 = $45.13. |
2. Upper Breakeven Point : Higher Strike Price - Debit
|
From the above Bull Put Butterfly Spread example :
Debit = $0.13 , Upper Strike Price = $47.00
Higher Breakeven Point = $47.00 - $0.13 = $46.87. |
In this case, our Bull Put Butterfly Spread makes a maximum profit of $87 if the QQQQ closes exactly at $46 during August Expiration and remains profitable if the QQQQ closes within the price range of $45.13 to $46.87.
Advantages Of Bull Butterfly Spread:
Disadvantages Of Bull Butterfly Spread:
Adjustments for Bull Butterfly Spreads Before Expiration :
1. When it is obvious that the underlying stock is going to go up beyond the middle and higher strike, you could close out the middle and higher strike legs and then just hold the lower strike leg, turning it into a long call position. This transformation can be automatically performed without monitoring using a Contingent Order.
|
Don't Know If This Is The Right Option Strategy For You? Try our Option Strategy Selector! |
| Javascript Tree Menu |
Important Disclaimer : Options involve risk and are not suitable for all investors. Data and information is provided for informational purposes only, and is not intended for trading purposes. Neither www.optiontradingpedia.com, mastersoequity.com nor any of its data or content providers shall be liable for any errors, omissions, or delays in the content, or for any actions taken in reliance thereon. Data is deemed accurate but is not warranted or guaranteed. optiontradinpedia.com and mastersoequity.com are not a registered broker-dealer and does not endorse or recommend the services of any brokerage company. The brokerage company you select is solely responsible for its services to you. By accessing, viewing, or using this site in any way, you agree to be bound by the above conditions and disclaimers found on this site.
Copyright Warning : All contents and information presented here in www.optiontradingpedia.com are property of www.Optiontradingpedia.com and are not to be copied, redistributed or downloaded in any ways unless in accordance with our quoting policy. We have a comprehensive system to detect plagiarism and will take legal action against any individuals, websites or companies involved. We Take Our Copyright VERY Seriously!
Site Authored by