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Short Butterfly Spreads: Finding Good Candidates

Short Butterfly Spreads: Finding Good Candidates

Key Points
  • A short butterfly spread is a breakout strategy generally used when you expect the underlying stock (or ETF) to move sharply in either direction.

  • Consider securities that are trading near an available option strike price, with a recent history of big up and down moves.  

  • We review how to set up a short butterfly spread. 

short butterfly spread is a three-legged breakout strategy. It is generally used when you expect the underlying stock (or ETF) to move sharply higher or sharply lower, but you are unsure of the direction. 

The short butterfly spread strategy involves three different strike prices established in a 1/2/1 ratio; it can be built with either calls or puts and can be created with the following actions:  

  • Sell one call (put) at the lowest strike price,
  • Buy two calls (puts) with a middle strike price
  • Sell one call (put) with the highest strike price.

Short butterflies are often compared to long straddles, which involve the simultaneous purchase of a long call and a long put with the same strike price and expiration. As with straddles, you want to see a big move in the stock up or down, but short butterflies are slightly more conservative because the maximum loss in the event of too little movement, is lower.

Short butterflies also differ from long straddles as you collect a credit when the position is established, rather than paying a debit.

How to select stock candidates

Since your best chance of a profitable short butterfly spread trade will come from a stock that breaks out higher or lower, you need to search for stocks you believe might do this. For example, you might look at a stock that is typically volatile but has been unusually range-bound or less volatile recently.

Stocks that fit this pattern typically hit a point of resistance and then turn back. If you employ a short butterfly strategy and the stock breaks out of its range, your strategy should benefit both from the stock movement and a potential increase in volatility.

Another possible breakout candidate might be a stock that is simply always volatile and regularly makes sharp swings in either direction, although higher volatility also means higher risk.

Look for stocks with the following criteria:

  • Sharp price movements: They are expected to move sharply higher or lower than the current price.
  • Increasing volatility: They have lower than normal volatility, but you expect that their volatility could increase. This may come from a recent support or resistance consolidation, or possibly a pending news event like an earnings release.
  • Continued volatility: They may be very volatile and you expect them to continue that way.
  • Specific trading ranges: They are trading near an available option strike price, such as 35, 40, 42.50, 45, 50, etc.
  • Long straddle possibilities: They are a good long straddle candidate but you would like to lower your maximum loss if you are wrong.

While these criteria might sound overly restrictive, you may be surprised how many candidates you can find with only a little research. Then, it is often helpful to draw the important price levels on a price chart, such as those available in StreetSmart Edge®. This will help you not only visualize potential profits but also show stock price movements that may result in an unprofitable strategy.

How to calculate price levels

Let’s take a look at how to calculate the key price levels on a sample 2.50 point short call butterfly. Assuming stock XYZ is trading at $61.08, the following formulas will allow you to calculate the maximum gain, maximum loss, and upper and lower breakeven prices on any short butterfly trade. 

Example of a 2.50 point short butterfly spread:

Sell 10 XYZ Dec 57.50 calls   @ 4.00
Buy 20 XYZ Dec 60 calls        @ 2.08
Sell 10 XYZ Dec 62.50 calls   @ .72

Credit = 0.56 (+4.00 - [2x2.08] + 0.72)
Maximum gain = 0.56 (credit received) (occurs beyond the outside strike prices) or $560
Maximum loss = 1.94 (first strike – second strike + credit) or $1,940
Upper breakeven = $61.94 (second strike +maximum loss) 
Lower breakeven = $58.06 (second strike – maximum loss) 
Total credit and maximum gain from this trade = $560 (credit x number of spreads x option multiplier)
or (0.56 x 10 x 100)

Or, you can simply allow StreetSmart Edge to calculate the numbers for you, as shown below.

Calculating maximum gain, maximum loss and breakeven price for a short butterfly trade

Calculating maximum gain, maximum loss and breakeven price for a short butterfly trade

Source: StreetSmart Edge.

Once you know these important values, consider drawing them on an actual price chart to help you visualize the trade. You’ll probably want to include the outside strike prices of $57.50 and $62.50 (maximum gain levels) and the upper and lower breakeven levels of $58.06 and $61.94.

A convenient way to do this is to use the support and resistance lines, which are typically used for technical analysis, to illustrate the breakeven and maximum loss levels. Use the resistance line tool (red line) for the inner breakeven lines, and the support line tool (green line) for the outer maximum gain levels, as illustrated below.

Breakeven price thresholds

Breakeven price thresholds

Source: StreetSmart Edge.

This chart image was taken on November 3, 2014, with the December short butterfly having about 47 days until expiration. If XYZ is between $58.06 and $61.94 at the December option expiration, this trade will be unprofitable. The maximum loss will be reached if XYZ is at exactly $60 at expiration.

This trade will be profitable if XYZ closes above $61.94 at expiration, with the maximum profit of $560 occurring at any price above $62.50. It will also be profitable if XYZ closes below $58.06 at expiration, with the maximum profit of $560 also occurring at any price below $57.50.

As with most butterfly spreads, it is pretty unlikely that the stock will close exactly at the maximum loss price of $60. However, with a loss zone of 3.88 points ($61.94 – $58.06), this candidate still has to move up more than 0.86 points ($61.94 – $61.08) or down more than 3.02 points ($61.08 – $58.06) to end up profitable.

Butterfly candidates with other profit and loss characteristics

Let’s review one more example to illustrate a good five-point short put butterfly candidate with different profit and loss levels. Assuming stock XYZ is trading at $93.57, the following formulas will allow you to calculate the maximum gain, maximum loss, and upper and lower breakeven prices on any short butterfly trade. 

Example of a five-point short butterfly spread:

Sell 10 XYZ Dec 90 puts  @ 0.82
Buy 20 XYZ Dec 95 puts  @ 3.25
Sell 10 XYZ Dec 100 puts @ 7.35

Credit = 1.67 (+0.82 - [2x3.25] + 7.35)
Maximum gain = 1.67 (credit received) (occurs beyond the outside strike prices) or $1,670
Maximum loss = 3.33 (first strike – second strike + credit) or $3,330
Upper breakeven = $98.33 (second strike + maximum loss) 
Lower breakeven = $91.67 (second strike – maximum loss) 
Total credit and maximum gain from this trade = $1,670 (credit x number of spreads x option multiplier)
or (1.67 x 10 x 100)

Or, you can simply allow StreetSmart Edge to display this data.

Calculating maximum gain, maximum loss and breakeven price for a short butterfly trade

Calculating maximum gain, maximum loss and breakeven price for a short butterfly trade

Source: StreetSmart Edge.

The lines you’ll want to show on the chart are the outside strike prices of $90 and $100 (represented by the green lines) and the lower and upper breakeven levels of $91.67 and $98.33 (represented by the red lines). As in the previous example, I've used the support and resistance line tools to mark up the following chart.

Breakeven price thresholds

Breakeven price thresholds

Source: StreetSmart Edge. 

This chart image was taken on November 3, 2014, with the December short butterfly having about 47 days until expiration. If XYZ is between $91.67 and $98.33 at the December option expiration, this trade will be unprofitable. The maximum loss will be reached if XYZ is at exactly $95 at expiration.

This trade will be profitable if XYZ closes above $98.33 at expiration, with the maximum profit of $1,670 occurring at any price above $100. Likewise, the trade will also be profitable if XYZ closes below $91.67 at expiration, with the maximum profit of $1,670 also occurring at any price below $90.

As with most butterfly spreads, it is very unlikely that the stock will close exactly at the maximum loss price of $95. With a loss zone of 6.66 points ($98.33 – $91.67), this candidate would have to move up more than 4.76 points ($98.33 – $93.57), but down only more than 1.90 points ($93.57 – $91.67) to end up profitable.

While both of these examples require a fairly substantial move in order to reach profitability, and should only be used when you expect a big move, many option traders prefer short butterflies to long straddles because the premiums received from the legs that are sold allows them to be entered at a net credit, rather than at a net debit.

I hope this enhanced your understanding of short butterfly spread candidates. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)

Next Steps

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