By Josip Causic, Online Trading Academy Options Instructor

Let us go over our example that we have been beating on for the last several weeks. The specifics are described in the article, Butterfly: Part II, but here is a brief recap of it. I had a long Butterfly spread; namely the 41/43/45 Call Butterfly. I purchased the lower (41) strike call, sold two of the middle (43) strike calls, and also bought the higher (45) strike call. The basic composition, line by line, reads:

BTO + 1 Feb (lower strike) 41 call @ $2.46 (debit)
STO – 2 Feb (middle strike) 43 calls @ $1.20 (credit)
BTO + 2 Feb (higher strike) 45 call @ $0.51 (debit)

In simpler words, I have bought the (41 & 45) wings and sold the (43) body. Mathematically, the debit on the bought calls is $2.46 + $0.51 = $2.97. I have sold two times the February 43 calls, $1.20 x 2 = $2.40. When we subtract the total credit from the debit, then we get $2.97 – $2.40 = $0.57, which is the cost of this Butterfly.

The Maximum Loss (Max L) is the debit or the amount that was paid up front to put this Call Butterfly on.

Max L = $0.57

The Maximum Profit (Max P) is calculated by subtracting the lower (41) strike price from the higher (45) strike price, dividing it by two, and then subtracting the debit from it. In our case, Max P = [(45-41)/2] – $0.57 debit; [4/2] = $2 minus the debit of $0.57, which is $1.43

Max P = $1.43

The Break Even Point(s) (BEPs) are two. One is the higher strike minus the debit; specifically 45 –$ 0.57 = $44.43. The second BEP is the lower strike price plus the debit or 43 + $0.57 = $43.57.

In this particular example, I have used two points for the spread of the wings on each side. The other choice could have involved a one point wing span (41/42/43) or three points (40/43/46). In either of those cases, the Max P would be calculated the same way as I have described above.

Now for a moment, let's consider this trade. We are risking only $0.57 cents to make $1.43. If we put these numbers into the rate of return (ROR) formula, we would we get a 251% rate of return on our initial investment. Yet at this point, we also need to ask ourselves what is the probability of the Max P happening, giving us that huge rate of return? Below, five possible outcomes are presented. The first couple of scenarios are the easiest to explain so I will start with them.

Scenario 1: At expiry, the stock closes at 40 which equals to the Max Loss of $0.57.

Scenario 2: If the stock closes at 46, it also achieves Max Loss.

The next three scenarios show what takes place when the stock price closes within the spread.

Although the above outcome looks very attractive, the probability of our Butterfly landing exactly on the 43 strike price is very low. Any of these next two scenarios have a much better chance of taking place. They do not achieve the maximum profit, but only partial profit.

In conclusion, multiple possible outcomes for the long 41/43/45 Call Butterfly have been presented here. An option trader must be aware of every one of these scenarios beforehand and have already planned out what they would do for each one. Out of all the scenarios presented, I would not have allowed my trade to get to the point of Max L as in either Scenario 1 or Scenario 2. This trade was a spread trade which aims at profiting from time decay, so there are both time and price concerns involved in planning your exits. You must always monitor Butterfly trades; they are not a place-it-and-forget-about-it strategy. Once it is planned, it is so easy to follow your predetermined course of action. Once again, plan your trade exits beforehand, and trade your plan. To learn more about how to plan Butterfly exits based on price and time, call an Education Counselor at Online Trading Academy and sign up for one of our Options classes. Good trading.

- Josip Causic

DISCLAIMER:
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

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