Hey Trader,

Last week we went over some of the basics about spread trades …

This week, we’re going to kick it up a notch …

And talk about one of my FAVORITE spreads to trade!

Spreads are incredible, but too many traders are intimidated by them.

And with some of the terminology (“what the heck is an iron condor?”), I get it. They can LOOK intimidating.

But honestly, once you know what you’re looking at … they’re just as simple as trading calls and puts.

And there’s some huge perks to using them, like being able to reduce your trade cost, limit your risk, and target specific options pricing factors to profit from …

I’m going to break down one of my favorites right here, and you’ll start to see how easy they can be.

The Butterfly Spread

I’m going to start with what I would argue might be my favorite type of trade to put on …

The butterfly spread.

This is one of those spreads that causes people to zone out, or run away screaming in the other direction.

Which is silly, because it is not as hard as you think.

Now, last week we talked about call spreads and put spreads … and went over how they can either be bullish or bearish.

Well, a butterfly is pretty much just combining two call or put spreads.

Seems easy enough, right?

For a basic long call butterfly, you are executing a bull call spread (buying a call at a lower strike and selling at the higher strike) and a bear call spread (selling at the lower strike and buying at the higher strike) at the same time. These two spreads “overlap” at the sold calls, which creates the “body,” while your long call positions are the “wings.”

When you do this, you want the underlying to end up as close to the strike sold as possible, as that will net you maximum profits. This is generally considered a “directionally neutral” trade, since it is most commonly opened with the short strikes being at-the-money, so it is looking for the stock not to move in order to make money.

So say stock XYZ is currently trading at $50, and you don’t expect much movement between now and your chosen expiration.

An example of a butterfly trade you could open would be to buy one 45-strike call, sell two 50-strike calls, and buy one 55-strike call.

Or, here’s an example of long call butterfly trade our Capitol Gains traders put on in September:

For a standard butterfly trade, you want the “wings” (in this case, the long 45-strike and 55-strike calls) to be equidistant from the “body” strike. If you choose to open your long strikes at different distances from the middle “body” strike, this creates a “broken wing butterfly,” which I’ll touch on briefly here in a minute.

But let’s stay focused on our standard butterfly here. 

Why would we do something like this?

The biggest upside is this spread limits your risk. The maximum loss is the cost of opening the trade. Compare this to, say, a short straddle, which is also directionally neutral, but opens you up to significantly heavier losses.

And the maximum reward? To figure that, you’d take the difference between the long and short strike price (so in the example above, $5) less the cost of opening the trade.

So if the trade above cost you a debit of $1.25 to open, your maximum loss would be $1.25, while your maximum gain would be $3.75.

Now, there are quite a few variations on the butterfly …

For example, long put butterfly involves buying the “wings” and selling the “body,” just like in a long call butterfly. However, you are using puts to construct the trade instead of calls. The maximum profit and maximum loss is the same as the long call butterfly.

Here’s an example of what a long put butterfly trade alert would look like …

Then there is the inverse of what we just talked about, the short call butterfly, where you would sell the “wings” (using the example above, you would sell the 45-strike and 55-strike calls) and buy two calls at the “body” (50-strike). In this trade, you want the underlying to move above or below the sold strikes.

The short butterfly is done for a credit, which is your maximum profit. Meanwhile, your maximum loss would be the difference between the short and long strikes, minus the credit received.

And of course, there is a short put butterfly, which also involves selling one put at the highest and lowest strikes, and buying two puts at the middle strike. Like the short call butterfly, this trade is done for a credit, which is your maximum profit.

Simple enough, right?

What other types of butterflies are there? Let’s look over two more variations.

Like I mentioned earlier, you can construct a broken-wing butterfly. For a long call broken wing butterfly, you would essentially construct the same trade as the one above – buying a call the lowest and highest strikes, and selling two calls in the middle – except this time, the “wings” are not equidistant from the body. Typically, you would take the highest strike and go out even further – for example, instead of buying the 55-strike call, you’d buy the 60-strike call. This means the trade is done for an even lower cost, or even a credit.

You still want the underlying to be equal to the middle strike of the short calls at expiration, but the broken-wing profile gives the trade a slight directional “tilt,” as your risk is greater to the upside.

Here’s an example of a broken wing butterfly trade sent out in December to Capitol Gains traders:

If you didn’t know how the heck to read that before, you do now! You’d buy puts at the 16-strike and 20-strike, and sell two 19-strike puts.

Easy-peasy!

Finally, let’s take a look at the iron butterfly.

The iron butterfly has a significant difference from the butterflies above, and that is that the iron butterfly involves both puts and calls.

A short iron butterfly is essentially a short straddle (selling a call and a put at the same strike), which makes up the middle “body,” and buying a long strangle (buying a call and a put at different strikes) to form the “wings.” You can also think of it as a short call spread and a short put spread.

So for example, on stock XYZ trading at $50, you would buy a 45-strike put, sell a 50-strike call and 50-strike put, and buy a 55-strike call. When you’re putting on this trade, you typically want to receive a net credit.

Your goal here is really the same as a typical short straddle seller (you want the shares to stay close to the sold strike), but by buying the strangle, you’re able to reduce some of the enormous risk typically associated with selling a straddle. Rather than having huge risk on both the upside and the downside, your maximum risk is limited to the difference between the long and short strike, minus the credit received.

To open a long iron butterfly, you are essentially opening a long call spread and a long put spread. Or, you could view it as buying a long straddle (purchasing a call and a put at the same strike), and selling a short strangle against it (selling a call and a put at different strikes).

Either way, you’re buying a call and a put at the middle “body” strike, while selling a put at a lower strike, and selling a call at a higher strike to create the “wings.” This is typically done for a debit, so you are paying to put this trade on.

What you want here is for the underlying to move above or below the strikes sold (the wings), which is when you’ll achieve your maximum profit.

Meanwhile, your risk is limited to the debit paid to put on the trade! Again, this is seriously limiting the risk compared to simply selling the short strangle, and you’re greatly reducing your cost (and therefore risk) compared to buying a long straddle outright.

I could write about butterflies all day … there’s even more variations than I’ve listed here, and I could really dig into the nuances of portfolio and trade management, the Greeks of these trades, and so on …

But the above should at least give you a general idea of what exactly a butterfly entails, and hopefully now you realize … they aren’t as complicated as you may have thought!

Your Only Option,

Mark Sebastian