If you can’t decide how aggressive or conservative you want to be in the stock market, butterfly spreads might be the option for you. They use both bull and bear tactics to create a healthy balance between risk and reward. Butterfly spreads do, however, require a degree of complexity not normally found in your average put or call option, so I wouldn’t recommend diving head first into untested waters.
Concerns have been voiced about the practicality of butterfly spreads, but these stem mostly from investors who argue that you’ll never get rich off butterfly spreads. This is true. But getting rich in the stock market is easier said than done, and you can still make excellent money with minimal risk, as I’m about to show you. In any case, it’s good to know your options, and you can jump on the accelerated path with this options profit mini course.
Butterfly Spread Explained
The butterfly spread is really a combination of two spreads: a bull spread and a bear spread. This is created by using four options, which can be made from put or call options. Two of these options create a bull spread, and the other two create the bear spread. While there are several varieties of butterfly spreads, the most common is the long call butterfly (put simply, this means the investor is expecting the price of the stock to remain relatively constant). Fortunately, the long call butterfly is both the most common and the easiest to explain. Once you grasp this concept, you should be able to understand how put options can also be used. If you’re having troubles, you might benefit from this article that goes into more detail on call and put options.
Risk vs. Reward
Risk vs. reward, in dollar amounts, varies with every butterfly spread, but you can get the general idea by looking more closely at the options we have to buy and sell. In total, we will be purchasing two options and selling two options. Keep in mind that with a long call butterfly we are predicting that the price of the stock will remain relatively constant. Thus, the two call options that we sell are going to be right at-the-money (that is, the strike price will be the amount that the stock is trading for). The third option will be purchased with a strike price in-the-money, and the fourth, obviously, will be purchased with a strike price out-of-the-money.
In this way, you create an option sandwich: one purchased call on either side of the trading price (the bread), and two sold calls smack dab in the middle (the meat). True to the metaphor, the meat is where the money is: butterfly spreads are most profitable when the stock price remains constant. You can eliminate guesswork with this essential options strategy course that covers the six main types of options.
The risk is minimized because the most you can lose is the amount required to establish your position; in this case, the amount you pay to purchase to two call options subtracted by the amount you are paid to sell the other two call options. In other words, if you invest $500 into a butterfly spread, then $500 is the most you can lose; you cannot get screwed by a tanking market and somehow lose $10,000.
It is possible to break even with butterfly spreads (better than losing, no?). This happens when the stock price ends roughly halfway between the in-the-money or the out-of-the-money strike price. It is then offset by the premiums paid or earned.
Let’s look at an example using stock ABC. In March, ABC stock is trading for just over $75. Since we are implementing a long call butterfly spread, we are expecting the price to remain fairly constant. The success of the butterfly spread relies entirely on picking the right stocks. This can really only be predicted on a short term basis, but you can get some much needed advice from this stock selection mastery course. So let’s say that we buy our calls for April (a standard call by month expires on the third Friday of that month).
We are going to sell two April 75 calls for $350 each ($700 total), we are going to buy an April 80 call for $280 and also an April 70 call for $600. Out maximum loss, then, is going to be our two purchases minus our two sales: ($280 + $600) – ($700) = $180.
Now, there are a number of things that can happen. First, let’s look at a worst case scenario. Let’s say the stock drops to $69 by the third Friday in April. This renders everything we have worthless; nobody is going to buy stocks worth $69 a share for $70 a share. In this case, we simply lose our original investment: $180.
Second, we can have something of a break even point. Let’s say the stock closes at $72. We still can’t do anything with our April 80 call, but we can exercise our April 70 call. Since a call option contract includes 100 shares, this option is going to be worth $200 (($72 – $70) * 100). But we still have to subtract our initial investment of $180, which leaves us with a meager $20. Hardly worth the effort.
Third, the stock could skyrocket to $81. We have a different problem as we did in the first scenario. Essentially, any profit we would make by exercising our April 80 call would be offset by the losses we would sustain from our other calls. This would also leave us with our initial investment: -$180.
Fourth, we can make the most money if the stock closes at $75. In this scenario, we calculate profit by taking our middle strike price ($75), subtracting our lowest strike price ($70), multiplying this by the number of shares (100), and finally deducting our initial investment. Our maximum profit, then, is $500 – $180 = $320. Which really isn’t bad, considering you can almost double your investment in roughly one month’s time. Assuming, of course, market behaves as you would like it.
You can learn about another low-risk money making strategy with this free post on covered calls. The best course of action, in any case, is to consult a broker and plan a strategy together. Go to your meeting informed by taking a walk around the stock market first with this complete foundation course on investing.