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Option Trading Strategy: Setup a Butterfly Spread

May 20th, 2014

Hey it’s Sasha Evdakov founder of Rise2Learn. In this video I want to share with you exactly behind What the Butterfly is when it comes to Trading Options and why you may want to trade the Butterfly.

The Butterfly’s just a fancy name for a type of spread because it looks like a butterfly. You can trade a butterfly to the upside you can't really tell downside or you can trade it to collect option premium butterfly’s a very effective strategy because it uses a lot less margin and which means a lot less risk to be able to trade those larger dollar value stocks.

First I want to share with you exactly what the butterfly is and what it looks like on a regular diagram and then I want to show you in the trading program and how to set up the butterfly.

butterfly-spread-options-may.0017

This is what the butterfly construct looks like so that’s a profit picture and it looks like a Torso or the middle part up the butterfly with a little bit of a wings on the side. Now looking at this profit picture you can see that at the center of the butterfly is at 16 now that means that I've sold two contract at the sixty levels and then I've bought protection at 55 and 65.

This is where the wings or the maximum loss starts to happen. The most that we can make from a butterfly is going to be at the sixty dollar level so if we get at the sixty dollar level and we stay there and we don't move and the option expires and then that's where we make the most amount of money.

Normally you don't trade these in terms of holding down forever until expiration you typically will hold them maybe for a few days maybe you’ll hold them for a week or two, it really just depends even put them onto trade as a long position or a short position because butterflies are really great in terms of capital requirements in order to do directional trades and I'll show you that in a second.

butterfly-spread-options-may.0046

Now in this butterfly I have a tighter butterfly but if you take a look at this butterfly we have effect or wider butterfly where the legs or the wings on the side gets spread out further so where we still have our max profit at the sixty dollar level.

Now our max loss starts to take place at the forty five dollar level and the seventy-five dollars level. This gives us a little bit of a wider range unfortunately because we've widen the butterfly there's always something you have to give back in the market.

The market doesn't give you freebies so in this case the wider the butterfly you always usually have 8 shorter max profit or not as much as if you had a tighter one. Something to take into consideration so looking at the trade screen let's do a butterfly setup and we're here June 2014, 31 days out from expiration to set up a butterfly on Apple.

butterfly-spread-options-may.0082

This is just the calls on the left the puts on the right and I just want to show you that how the construct is made so what we're going to do is we're going to click this one right there at the money first and we're going to sell a single contract on there and we're going to do two because that's how it's created.

Now I’ve changed the order entry to blast all just so you could see it and then we're going to buy protection on both sides of this. So we're going to sell this one and then we'll buy protection on little bit in the money and a little bit out of the money.

It will do 3 in this example so we'll go ahead and this time we’ll buy a single at the 590 so that's 15 points out and then over here at the 615 level will buy a single. So these are the orders that I would put on and you can blast all to blast all of them and send it in or to do the order the easier way you can just do buy a butterfly position and it would create a butterfly position.

Let me show you what that looks like on the profit picture so here is my butterfly all positions are spread out for the time being just so you can see what's going on. It's not one single order are so that's three separate single order. We have our single sell, -2 on the June 14th. 605, so that would be right here this is our two right there in the middle and then we have our two wings at the 590 and the 620 level.

butterfly-spread-options-may.0089

The 590 is right here we buying protection it's a call and the 620 is right here again the call so those are the two that are there for protection. If we didn't have those you could see how our loss could continue further and further at negative seven thousand dollar loss if we don't have those wings are protection.

Now the butterfly looks similar to a calendar but the primary difference here is look at the Vega position where's the calendars positive Vega, this is negative Vega. The butterfly is great for different times in the market when volatility is slamming you on the calendars and it just continues to hammer you then you may want to trade and do a butterfly.

Now what you can also do is mix them up and do a butterfly and a calendar on different stocks or even the same stock but it's a little more advanced strategy but this helps you eliminate or reduce this Vega risk.

If for calendar you had a positive 13 and in this you -13 it would have a zero Vega effect. So all you're playing with is the beta.

Now here we have are thinner butterfly, I say thinner because mean I can tighten it up here and it appears thinner or we have it fatter but relatively speaking It’s still a thin butterfly because we're only two strikes out what we can do is move this to a little bit wider so let's just say we go to 630 here and now it's a lot more wider and we have a beta of 10 dollars almost ten dollars, nine dollars here.

Every single day we make money so here's how this works so our max losses – 762, -765 so if it goes at this range we can lose about that much our max profit’s around seventeen hundred dollars if it gets there and stays there but normally again we don't hold it all the way to expiration so even if we hold it for a few days so let's just say we hold it for a week or two you know we’re up 265 dollars and then we could take this position off.

Even down here at 594 we would make a hundred and seventy dollars if it’s up here again about 140 150 dollars so with prices stay fairly stable then you know we would make this amount of money.

Let's go back to today and what you can do is you can actually shift this butterfly if you believe the prices are going to head higher so let's just say we move it to 610 and now we adjust this to be fairly even of course you can do skewed butterflies and to where one of the wings are not leveled but let's just keep them even for now for easy sake.

Here we have it shifted a little bit so if you expect the price to run up again you can do the same concept and allow things to expire and deteriorate of course you have a little more risk here but normally what I like to do is just if I have a negative Vega, I like to have also a negative Delta because here you'll have additional volatility risk with the butterfly.

butterfly-spread-options-may.0185

These positions are better for calendar positions but instead because we have a negative Vega I typically like to go the other route on these positions and go something like this just because if we have a negative Vega I like to have a little bit of a negative Delta and it helps off set risk.

That's kind of the way I prefer to put on butterflies and that’s if I'm totally neutral this is a neutral position in terms of Vega and Delta. Now of course you need to watch the stock and what it's doing but this would be considered more neutral on a butterfly it would be considered neutral on a calendar if the calendar was further to the right.

Just take into consideration that neutrality is really referred to Vega position and the Delta position because you need to offset both.

That’s how the butterfly works as a little tip or side note you can play these to the upside and something that a lot of professionals like to do is to play these to the upside because its really great for data deterioration.

It’s almost sometimes better than a vertical unfortunately you do have multiple contracts that you're dealing with so you need to understand what you're doing but the way that would look like is something like this.

Here I've adjusted the strike prices in order to account for the butterfly and what I've done is put on the 625 as this middle region and the 635 as a wing and a 615 as a wing of course you can go wider if you'd like but basically here's our current price at 604, right now we’re 605 and if I’m looking for  upside direction I could put on this butterfly and the reason we do that is because it's a lot different of what happens.

My max loss first off is -130, -135 on both ends so the max loss is really good our max profit or potential is 865, 860.

What we can do is see what happens to this profit line the white line as time moves forward and you can see that what happens is on this butterfly what's great about it is that it goes to the edge or past these red lines.

That's one thing that's great for this butterfly is that it goes much further out whereas with a lot of other positions it doesn't do that so it'll allow you to as the stock continues moving higher here you know even if your max losses at -120 you’re able to make you know sixty or seventy dollars maybe even a hundred dollars almost a hundred percent on your investment here just for the sheer fact of it not even going in between what you selected but just a little bit you know overtime.

That's one of the things that people do with the butterflies as far as professionals go is they put him on as directional trades not just for Theta exploration so just something for you to think about for the time being but I just want to give you a little more insight behind how these are setup in other ways not just for Theta exploration but using the power of direction and also data deterioration.

Thanks again for watching.

Remember to do what you love, contribute to others, and most importantly live life abundantly.

Author: Sasha Evdakov

Sasha is the creator of the Tradersfly and Rise2Learn. He focuses on high-level education speaking at events, writing books, and publishing video courses on business development, internet marketing, finance, and personal growth.

I'm Sasha, an educational entrepreneur and a stock trader. In addition to running my own online businesses, I also enjoy trading stocks and helping the individual investor understand the stock market. Let me share with you some techniques & concepts that I used over the last 10+ years to give you that edge in the market. Learn More

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