I love trading butterflies in this market.
They create low-risk bets with huge profit potential.
But how wide do I make my butterfly?
I want to take you inside my decision-making process.
There’s an obvious tradeoff between distance and payout.
Increase the distance and you decrease the payout while increasing the odds of success.
Here’s a great example from my Weekly Money Multiplier.
*See disclaimer below
This trade cost me $360 per spread to put on.
My potential payout was a whopping $4,640 per spread!
Yes, I took it off much earlier than max profit.
There’s a method to the madness.
It all starts with picking the strike distance.
And to do that, we need to dig in a little more to the tradeoffs.
For those of you who aren’t familiar, I’m going to layout the butterfly basics.
The payoff graph looks something like this.
Maximum payout occurs at expiration at the middle strike.
Here’s the important point – You can’t get to maximum payoff until the actual expiration.
And that also comes with assignment risks!
Let’s take my Amazon butterfly as an example.
A butterfly sets up as follows:
- I bought 2 call contracts expiring August 21st at the $3250 strike
- I sold 4 call contracts (twice the amount of the first) expiring the same date at the $3300 strikes
- I bought 2 call contracts (same as the first) for the same expiration at the $3350 strike
All this cost me $3.60 per spread or in this case $720 for two of them.
Maximum payout is the distance between the strikes minus the amount I paid for the trade.
In this case that’s: $3300 – $3250 – $3.60 = $46.40 x 100 shares = $4640.
Maximum loss is limited to the amount I paid to initiate the trade.
Key points for the butterfly
Rather than draw out the conclusions, I want to deliver some key ideas.
- Maximum payout only occurs at expiration.
- I use put butterflies for when I want a stock to move down to the price and call butterflies for when I want it to move up to a price.
- For any stock, if I hold to expiration, I will risk assignment.
- This means I could be forced to buy or short shares by my broker
- While this doesn’t always happen, it can leave me with a position to start the following week that I hadn’t intended
- Because of the previous point, I never hold butterflies to expiration unless it is a cash-settled options index like the SPX.
This last point is the big one and one I want to repeat.
I never take my butterflies to expiration unless it’s a cash-settled index.
Using that last point as the launchpad, I want to show you what the payoff graph looks like over time for a butterfly.
As you get closer to expiration, the payout potential grows near the midpoint.
Unfortunately, you really need to be in the last 24-48 hours to get any sort of profit in most cases.
Knowing this, I opt to increase my odds of success by increasing the strike width.
You see, the wider I put the strikes, the higher the chance the stock lands somewhere in between the day of expiration or just before.
That gives me more opportunities to take the trade off at a profit instead of trying to ‘pin’ it to a specific price.
Let me use the Amazon example.
I set my strikes $50 wide, or $100 in total, giving me about a 3% range on the stock.
I could have put on the trade much cheaper, say $0.50 if I chose the $3290/$3300/$3310 strikes.
But then I would only have a $20 range in total to play with or a little more than half a percent.
Sure my max potential profits jump from around 13x my cost to around 19x, but the odds of success drop dramatically.
Now, I don’t want to put the strikes so wide that I can’t turn a profit at all.
In general, I try to go get a 1 to 5 risk to reward or as high as 1 to 10 when possible.
Also, I tend to only go out a week at most for expiration.
When I’m reading charts, my analysis rarely gives me much to work with beyond 10 days.
Learn to trade butterflies in real-time
I know a lot of newer traders struggle with setting these up.
That’s why I created my Weekly Money Multiplier.
With weekly training and access to my trades, you’ll get the inside scoop into the mind of a successful trader.