One of the limitations of trading stocks is that there is only one way to make money and that is picking the direction right. For example, if you buy a stock the only way, you’ll make a profit if it rises above your entry price. On the other hand, when you’re trading options, you are not limited to directional bets. In fact, you can make bets on where you think a stock will or won’t trade. You can even place bets on if you think a stock or ETF will move by a lot or a little. These types of options trades are focused on volatility more so than they are in a particular direction.
That said, there are many different options strategies that a trader can select when they’re expecting a volatility contraction; one of those strategies is known as the butterfly spread.
Mechanics Behind The Butterfly Spread
The butterfly options strategy involves four options contracts, and you can execute it with calls, puts, or a combination of the two.
The strategy looks to take advantage of stocks (or ETFs) set to be range bound.
Let’s take a look at a real-life trading example from trader Nathan Bear using AMZN options. In this trade, Nathan is using the butterfly spread to express a bullish position. Now, you might be thinking that’s a contradiction of what the butterfly spread is. That said, the butterfly spread can be constructed to be bullish, bearish, or neutral but it’s always a range trade.
For example, Nathan was looking at options that were trading about 31 days out and when the stock was trading near $1723 a share.
That said, the position he put on is as follows:
BUY 40 AMZN 1850 CALLS/ SELL 80 AMZN 1900 CALLS/ BUY 1950 CALLS.
Now, another way to look at this position is to look at as a set of call spreads. For example, it’s the same position as being long 40 AMZN 1850/1900 call spreads and being short 40 AMZN 1900/1950 call spreads.
Here is how Nathan explained it to clients:
Calculating Profit Potential and Break-Even Points
In this trade, Nathan was looking for AMZN to close near 1900 by the expiration date. For example, the goal of the trade is to make money on the long portion the 1850/1900 spread and have the 1900/1950 spread expire worthless.
With the spread being 50 points wide and Nathan paying 2.50 for the butterfly his profit potential was massive. Let’s do the math:
the most he can make on the $1850/$1900 spread is (50 points minus 2.50) is $47.50 (multiplied by 100) is $4750. That said, he put 40 on, so his max profit potential is $190K and his total risk the premium spent on the trade ($10,000).
As you can see, the risk to reward on this trade is phenomenal. But why?
Because you’re essentially saying you think you know where AMZN will be 30 days from now. In this case, Nathan was expecting AMZN to have a 180 point run up or about a 10% move in a month. Since the probability is considered low the payout is so high if you’re right.
The butterfly spread bets on stocks trading in a range, but you can set up the trades to be directional like Nathan did with this AMZN trade.
What You Need To See With A Butterfly
In a perfect world, AMZN closes at 1900 on the expiration date to receive the full profit potential. However, here’s the thing. You are betting that a stock will be trading within a certain date and time. For example, if AMZN were to reach 1900 with 2-3 weeks left the spread wouldn’t be as valuable.
Because this butterfly spread has components of a long call spread and a short call spread, you want the long side to make money (reach 1900), but you want the short side to expire worthless. So it’s all about timing with these types of trades. And unfortunately, that means you have to sit on these trades and be patient. To get cheap prices, you need to go about a month out or further. The butterfly only starts paying out until we reach about the final week till expiration.
Source: think or swim
Above is the PnL risk graph for Nathan’s butterfly trade. While some traders are happy receiving to 2-1 or 3-1 on their money, butterfly spreads offer some of the best risk/reward trades in the options market.
The butterfly spread takes advantage of a volatility contraction. If you think a stock will be rangebound, it’s a solid strategy to implore given its risk/reward features. However, the strategy is also flexible. For example, Nathan Bear was able to use the strategy as a creative way to get long AMZN on the cheap. The strategy consists of two spreads combined (a debit and credit spread) and is executed as a single order.
And you know what?
It paid off, big time.
While it didn’t reach max profit potential, he was able to sell some contracts for $14, making it his best single option trade ever. The stock didn’t get to 1900 but reached the 1860s which was enough to take down some enormous profits.
Keep in mind, they are slow trades and don’t start paying out until the last week or so until expiration.
That said, if you’d like to know more about options, I encourage you to check out my primer, 30 Days to Options Trading eBook.
If you’d like to learn more about Nathan Bear, you can read about him in the Millionaire Maker Blueprint.