Advanced Option Trading: The Modified Butterfly Spread

The majority of individuals who trade options start out simply buying calls and puts in order to leverage a market timing decision, or perhaps writing covered calls in an effort to generate income. Interestingly, the longer a trader stays in the option trading game, the more likely he or she is to migrate away from these two most basic strategies and to delve into strategies that offer unique opportunities.

One strategy that is quite popular among experienced option traders is known as the butterfly spread. This strategy allows a trader to enter into a trade with a high probability of profit, high profit potential and limited risk. In this article we will go beyond the basic butterfly spread and look at a strategy known as the "modified butterfly." (See also: Options for Beginners.)

Before looking at the modified version of the butterfly spread, let's do a quick review of the basic butterfly spread. The basic butterfly can be entered using calls or puts in a ratio of 1 by 2 by 1. This means that if a trader is using calls, he will buy one call at a particular strike price, sell two calls with a higher strike price and buy one more call with an even higher strike price. When using puts, a trader buys one put at a particular strike price, sells two puts at a lower strike price and buys one more put at an even lower strike price. Typically the strike price of the option sold is close to the actual price of the underlying security, with the other strikes above and below the current price. This creates a "neutral" trade whereby the trader makes money if the underlying security remains within a particular price range above and below the current price. However, the basic butterfly can also be used as a directional trade by making two or more of the strike prices well beyond the current price of the underlying security.

Figure 1 displays the risk curves for a standard at-the-money, or neutral, butterfly spread. Figure 2 displays the risk curves for an out-of-the-money butterfly spread using call options.

Figure 1: Risk curves for an at-the-money, or neutral, butterfly spread

Source: Optionetics Platinum

Figure 2: Risk curves for an out-of-the-money butterfly spread

Source: Optionetics Platinum

Both of the standard butterfly trades shown in Figures 1 and 2 enjoy a relatively low and fixed-dollar risk, a wide range of profit potential and the possibility of a high rate of return.

The modified butterfly spread is different from the basic butterfly spread in several important ways:

1. Puts are traded to create a bullish trade and calls are traded to create a bearish trade.
2. The options are not traded in 1:2:1 fashion but rather in a ratio of 1:3:2.
3. Unlike a basic butterfly that has two breakeven prices and a range of profit potential, the modified butterfly has only one breakeven price, which is typically out-of-the-money. This creates a cushion for the trader.
4. One negative associated with the modified butterfly versus the standard butterfly: While the standard butterfly spread almost invariably involves a favorable reward-to-risk ratio, the modified butterfly spread almost invariably incurs a great dollar risk compared to the maximum profit potential. Of course, the one caveat here is that if a modified butterfly spread is entered properly, the underlying security would have to move a great distance in order to reach the area of maximum possible loss. This gives alert traders a lot of room to act before the worst-case scenario unfolds.

Figure 3 displays the risk curves for a modified butterfly spread. The underlying security is trading at $194.34 a share. This trade involves:

• Buying one 195 strike price put
• Selling three 190 strike price puts
• Buying two 175 strike price puts

Figure 3: Risk curves for a modified butterfly spread

Source: Optionetics Platinum

A good rule of thumb is to enter a modified butterfly four to six weeks prior to option expiration. As such, each of the options in this example has 42 days (or six weeks) left until expiration.

Note the unique construction of this trade. One at-the-money put (195 strike price) is purchased, three puts are sold at a strike price that is five points lower (190 strike price) and two more puts are bought at a strike price 20 points lower (175 strike price).

There are several key things to note about this trade:

1. The current price of the underlying stock is 194.34.
2. The breakeven price is 184.91. In other words, there are 9.57 points (4.9%) of downside protection. As long as the underlying security does anything besides declining by 4.9% or more, this trade will show a profit.
3. The maximum risk is $1,982. This also represents the amount of capital that a trader would need to put up to enter the trade. Fortunately, this size of loss would only be realized if the trader held this position until expiration and the underlying stock was trading at $175 a share or less at that time.
4. The maximum profit potential on this trade is $1,018. If achieved this would represent a return of 51% on the investment. Realistically, the only way to achieve this level of profit would be if the underlying security closed at exactly $190 a share on the day of option expiration.
5. The profit potential is $518 at any stock price above $195—26% in six weeks' time.

The three key criteria to look at when considering a modified butterfly spread are:

1. Maximum dollar risk
2. Expected percentage return on investment
3. Probability of profit

Unfortunately, there is no optimum formula for weaving these three key criteria together, so some interpretation on the part of the trader is invariably involved. Some may prefer a higher potential rate of return while others may place more emphasis on the probability of profit. Also, different traders have different levels of risk tolerance. Likewise, traders with larger accounts are better able to accept trades with a higher maximum potential loss than traders with smaller accounts.

Each potential trade will have its own unique set of reward-to-risk criteria. For example, a trader considering two possible trades might find that one trade has a probability of profit of 60% and an expected return of 25%, while the other might have a probability of profit of 80% but an expected return of only 12%. In this case the trader must decide whether he or she puts more emphasis on the potential return or the likelihood of profit. Also, if one trade has a much greater maximum risk/capital requirement than the other, this too must be taken into account.

Options offer traders a great deal of flexibility to craft a position with unique reward-to-risk characteristics. The modified butterfly spread fits into this realm. Alert traders who know what to look for and who are willing and able to act to adjust a trade or cut a loss if the need arises, may be able to find many high probability modified butterfly possibilities. (See also:  Understanding Option Pricing and What to Do When Your Trade Goes Awry.)