Spread trading is a foundational tool that you should have in your options trading toolkit. It will allow you freedom and flexibility for enhanced profit and will give you defense against potential loss while reducing your overall risk. Now, let us look at this fundamental of options trading, the spread trade.
We have demonstrated how well options function in unison with a stock position. They enhance potential gains, provide profit protection and limit the risk of the entire investment. They enable us to manage risk in a single stock as well as an entire portfolio. But, as good as options are in conjunction with stocks, they can be even better when traded against each other.
Spreads are strategies that do not involve the use of any security other than another option. Their positives are that they are inexpensive, offer protection for both buyer and seller and are in effect automatically hedged trades.
Spreads can provide large percentage returns with low risk and can be entered into with small capital outlay. A spread involves the purchase of one option in conjunction with the sale of another option. There are many types of spreads. Some take advantage of stock movements while others are set up to take advantage of movements in implied volatility and even time decay. There are calendar or time spreads, diagonal spreads, ratio spreads and also vertical spreads, which we will discuss in depth here.
Spreads are more advanced and sophisticated than the strategies discussed in our beginner product 'OPTIONS 101.' Where certain spreads, like 1 to 1 vertical spreads, can be less risky than a buy-write, there are more variables to consider and control which makes trading the spread more complicated.
When you trade a spread you are dealing with three elements: the spread as a whole (which you can buy or sell) and its component parts - the option you buy and the option you sell.
Although the cost of most spreads is relatively inexpensive to initiate, they can provide a large percentage return and there is protection (limits) to both sides of the trade. Therefore, even experienced investors can profit from learning about spreads and their investment potential.
I am sure many of you have heard of a sophisticated sounding strategy called the Butterfly. For some reason, it seems to be the darling strategy of many of those 'teach-you in five hours' type option companies. They publicize the 'mystical magical Butterfly' and the 'sophisticated Condor' as if they were going to unlock the options version of Pandora's box. I guess they feel that, by introducing you to the catchy named strategies, they will grab your attention and thereby give them a chance to promote themselves. From a marketing standpoint, that is not a bad idea.
However, the Butterfly is a 'sophisticated' only for those that do not know options! If you have done your homework and have learned the option basics properly, then the Butterfly is a simple strategy that is just a combination of an already familiar, basic strategy. Let's take a closer look and uncover the secrets of the mysterious Butterfly!
Butterfly Construction The first thing you must understand about the Butterfly is that it is constructed by using either all calls or all puts. The Butterfly is never a combination of the two. (We will talk about an exception called the Iron Butterfly later.)
Whether you choose to use calls or puts, butterflies are always constructed in a '1-2-1' arrangement. For the long Butterfly, you would buy one low strike, sell two medium strikes and buy one high strike with the strike prices equally spaced. The center strike typically matches the current price of the stock.
For example, if the stock is 55 and you decide to create a long Butterfly by using calls, you could buy a 50 call, sell two 55 calls, and buy one 60 call. If you decided to use puts, you could buy a 50 put, sell two 55 puts, and buy one 60 put. The long Butterfly is always long the outer strikes and short the center strike.
You would construct the short Butterfly in the opposite way. The short Butterfly will always be short the outer strikes and long the center strike. For example, to create a short Butterfly, you could sell a 50 call, buy two 55 calls, and sell one 60 call. The short Butterfly trader is simply taking the opposite side of the trade with the long Butterfly trader.
This is not a complicated construction. The trick is to understand that while there are three strikes to a Butterfly, there are four options involved. I know the construction will be hard to associate with long or short in the beginning, so here is a little trick or two to help you remember how to differentiate a long Butterfly from a short Butterfly. When I think of whether a Butterfly is long or short, I always look at that first strike. If that first strike is long, then it is a long Butterfly. It is as simple as that. Some people find it easier to just focus on the center strike where you have the two-option position. If you are short the center strike, then you are long the Butterfly.
The opposite would be true for short butterflies. These are just a couple of ways that you can determine whether a Butterfly is long or short until you become so familiar that you automatically know which Butterfly is which. Until you get to that point, you will want to use little tricks to remember which one is which. Use whichever is most comfortable but I suggest you focus on only one 'trick' and use only it until you become so familiar with butterflies you don't need it any longer to recognize which one you have. Make your choice and stick with it!
The following chart shows the long and short Butterfly construction:
Notice that the strike prices are equally spaced. This is a necessary aspect of all butterflies. However, while the strikes must be equally spaced, they do not need to be spaced by five dollars as in this example.
We could have spaced them by ten dollars and created a different long Butterfly by purchasing the 45 call, selling two 55 calls, and buying one 65 call. You just have to understand that the strikes must be set up in an equidistant manner and they must be either all calls or all puts in the proper 1-2-1 ratio.
From a terminology standpoint, we call this the 50/55/60 Butterfly or, more simply, the 55 Butterfly taking the lead from the Butterfly's middle strike.
We add to that term whatever month you are dealing with. If we are referring to the June expiration cycle, it would be called the June 55 Butterfly. If we were in April, it would be called the April 55 Butterfly.
Ron Ianieri has sinced written about articles on various topics from Options Trading, Real Estate and Options Trading. Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at. Ron Ianieri's top article generates over 4400 views. to your Favourites.