The only disadvantage of a directional butterfly spread is that its maximum profit potential is reached close to expiration. A trader will have to be patient which is usually a good quality for a trader to have.
Butterfly spreads are generally thought of as being a neutral strategy. The long butterfly spread involves selling two options at one strike and the purchasing options above and below equidistant from the sold strikes.
What some traders don’t realize is that butterfly spreads can be used directionally by moving the body of the butterfly out-of-the-money and using wide strike prices for the wings. This lets the trader make a directional forecast on the stock with a fairly large profit zone depending on the size of the wings.
The logic behind the trade is that the trader has a specific target and time frame for the stock, but wants to give himself some cushion. The goal of the trade is to benefit from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value and the lower strike call on a long call butterfly or higher strike put for a long put butterfly have intrinsic value.
The first thing a trader needs to do is come up with a forecast for the stock; price and time. If the trader is more confident about the price target, he can narrow the wings and the cost of the spread. If the trader is less confident and wants a bigger profit zone, he can expand the wings of the spread but that also expands the cost of the trade. It’s a trade-off, like a lot of things in life.
Let’s go through an example and talk about best and worst-case scenarios:
It’s the end of June and AAPL is trading in the $325 area. You think that by August expiration that the stock has a real good chance of being in the $360 area but would like to give yourself some leeway just in case. A $20 cushion on both sides of $360 makes sense to you.
The butterfly spread will be buy one August 340 call for $8.00, sell two August 360 calls for $2.75 each and buy an August 380 call for $0.90. The total cost of the spread will be $3.40 which is the most that can be lost. The maximum profit will be $16.60 ($20 strike difference – $3.40 debit).
Since the butterfly has two wings there are two break-even points. Add the net debit to the lowest strike and subtract the net debit from the highest strike. For this trade it’s $343.40 ($340 + $3.40) and $376.60 ($380 – $3.40). AAPL can trade between $343.40 and $376.60 at August expiration and the trade will be profitable. Anywhere outside of that area and the trade will not be profitable. If AAPL finishes at $360 on August expiration, the maximum profit is achieved ($16.60).