Butterfly spreads are generally thought of as being a neutral strategy. The long butterfly involves selling two options at one strike and the purchasing options above and below equidistant from the sold strike.
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 leeway. The strategy and 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 in terms of both price and time. The more narrow the wings of the butterfly, the lower the cost of the trade. If the trader wants a bigger profit zone, he can expand the wings of the spread but that also increases the cost of the trade and, thus, capital at risk.
Let’s go through an example and the best and worst-case scenarios:
It’s the middle of September and AAPL is trading in the $390 area. A trader thinks that by October expiration that the stock has a good chance of being in the $400 area but would like to give himself a little margin of error just in case. A $10 cushion on both sides of $400 makes sense to him.
The butterfly will consist of buying one October 390 call for $16.70, selling two October 400 calls for $11.55 each and buying an October 410 call for $7.70. The total cost of the spread will be $1.30, which is the most that can be lost. The maximum profit will be $8.70 ($10 strike difference – $1.30 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 $391.30 ($390 + $1.30) and $408.70 ($410 – $1.30). AAPL can trade between $391.30 and $408.70 at October expiration and the trade will be profitable. Anywhere outside of that area and the trade will not be profitable. If AAPL finishes at $400 on October expiration, the trader achieves the maximum profit ($8.70). Transaction costs are excluded.
The only disadvantage of a directional butterfly is that its maximum profit potential is only reached when the options are very close to expiration. A trader will have to be patient—which, of course, is a generally good quality for a trader to have.