If you want to actually learn how to trade options and beef up your trading arsenal…you’re going to need some tools. Well, what better way is there than to learn different strategies? You see, you’re going to need different profit buckets as you develop into a successful trader. Now, Kyle Dennis, who’s teaching people how to trade biotech stocks, defines a profit bucket as different strategies. For example, in different market environments, some strategies will work, while some may not. That said, it helps to learn different strategies to potentially maximize your profits. Now, let’s take a look at the butterfly strategy.
How to Trade Options – The Butterfly Strategy
Now, before we get started, you should understand the basics of options. That means you’ll need to know how puts and calls work, as well as expiration dates, volatility, and moneyness – just to name a few.
Moving on, let’s get into the butterfly spread. Here’s a look at the risk profile of a butterfly spread from thinkorswim at expiration.
Now, just by looking at this chart, what does it tell you?
Well, the peak of the profit and loss (PnL) diagram at expiration is around a certain price. Typically, those who use the butterfly strategy are betting that the underlying stock remains neutral. In other words, they think a stock isn’t going to be volatile and will trade in range. You can’t really do this with stocks, and that’s the beauty of options. You’re able to make money on crashing stocks using options, as well as hedge your portfolio.
You see, you would be hard pressed to make money in the stock itself if you thought it would trade in range. That’s why learning how to trade options could help you maximize profits.
Getting back. You’re probably wondering what this strategy entails. Well, the butterfly strategy involves:
- Buying 1 In The Money (ITM) option
- Selling 2 At The Money (ATM) options
- Buying 1 Out of The Money (OTM) option
Keep in mind, with this strategy your outlook is the stock will not rise or fall too much between the time you buy the options and the expiration date.
How to Trade Options – Butterfly Strategy PnL
Now, the maximum profit of the butterfly strategy is achieved when the price of the underlying is equal to the strike price of the short ATM options. Your maximum profit (when using call options) is calculated as:
Max Profit = (Short Calls Strike Price – Strike Price of ITM – Net Premium – Trading Costs) * 100 * # of contracts
Your maximum loss happens when the price of the underlying stock is less than or equal to the strike price of the ITM call option…or the price of the underlying stock is greater than or equal to the strike price of the OTM call. Your maximum loss is equivalent to the premium paid and commissions.
Pretty simple right?
Next time you think a stock may trade in range, maybe you could consider this strategy. However, you should learn and master how to trade options before you start putting your money on the line.
The butterfly strategy is useful in some situations, but you have to understand which market environments to use it in. Now, it’ll take some experience and practice…but there are some key things to remember about the butterfly strategy:
- It’s a neutral strategy and should only be used when you believe a stock or exchange-traded fund will trade in range.
- You could use calls or puts to create the butterfly strategy.
- It involves buying 1 ITM option, selling 2 ATM options, and buying 1 OTM option.
Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options and leveraged ETFs.