The option butterfly spread trade is often a treasured tactic among option income fanatics. Not only does this trade give the trader a considerable level of premium at the beginning of the trade which could be turned into a major monthly cash flow, it also provides a highly sturdy position structure which can take and endure a range of trading environments, including really volatile environments like the ones we are witnessing now. In a crazy stock market where several other option strategies do not have a chance, the butterfly spread may be put on and if appropriately maintained, wind up doing exceptionally well.
Whenever one looks at a risk graph of the buttefly spread, it is apparent that the butterfly spread payoff is massive – in particular when compared to other option spread approaches for example the iron condor, the credit spread, the diagonal, double diagonal, the calendar, double calendar, etcetera.
Depending on exactly where the wings are placed on these trades, or to put it differently, how close or far the long options are puchased in relation to strikes sold, it’s possible to develop a butterfly trade where by the possible reward is numerous times more than the danger taken on.
Even so, in the situations where the reward in the trade is so many times greater than the maximum possible loss in the trade, it is because the wings which are being bought are very close to the sold short strikes in the trade – creating a quite tall yet highly narrow ‘profit income tent’ – which the underlying needs to stay within throughout the duration of the trade to realize that massive payoff – which the odds will probably be extremely low.
Even so, if the underlying remains inside the overall space of this tall, narrow profit tent – plus the trader does not plan to stay with the trade all of the way until expiration day – a good earnings can still be extracted from these lower probability butterfly spread trades as the zero day income line on the risk graph soars up pretty rapidly and a first rate return is usually grabbed within a short level of time.
Ted Nino is an option selling evangelist – particularly fanatical about trading the Butterfly Spread, the Double Calendar, the Credit Spread, and the Butterfly Spread. Visit his Butterfly Spread Blog to learn more about this option strategy.