What is the Butterfly Spread Strategy?
A butterfly spread is essentially the combination of a bull call spread option on a bearish gap option. The butterfly spread is designed to make money if the stock remains in a relatively narrow trading range. The great thing about this kind of strategy is that it presents a limited risk. Not only that, but the butterfly spread strategy also offers a high risk and high return scenario.
Having understood the positive side of this operation though, you might struggle to execute it as an individual investor - as it would be very difficult to implement due to the wide range of investments.
Here's how the butterfly spread strategy works. Suppose XYZ is trading at $50.00 per share. If you think the action will remain in a trading range of $40.00 to $60.00 US Dollars between now and the end of May, you can use a butterfly spread. Suppose that current prices are as follows: the May 40 call options are trading at $ 13.00, the May 50 call options are trading at $ 7.50 and options are traded on May 60 3 , $50.
The butterfly spread involves buying one XYZ May 40 (price $13.00), to sell two call options XYZ May 50 ($7.50 x 2 = net credit of $15.00 ) and buy an XYZ May 60 ($3.50). Buying call options May 40 and May 60 will cost a total of $16.50 per share. The sale of two options May 50 will give you a credit of $15.00 per share. Your total risk is the net cost of$ 1.50 – which represents the constitution of the spread.
Earn Money with Options Trading
It is possible to earn money on this if the action is between $41.50 and $58.50 at the end of May. For example, if the stock closed at $45.00 US Dollars then the XYZ May 50 and the XYZ May 60 options will expire and be worthless. However, you could sell your option XYZ May 40 at $5.00 a share. If you were to do this then your net income would be $3.50 per share (i.e. $5.00 minus the cost of $ 1.50).
Ideally, the action reaches exactly $50.00 at expiration. At that time, the options May 50 and May 60 would expire and again be worthless, but your call May 40 would have a value of $10.00 per share. In other words, to $50.00 per share, so you will earn a profit of $10.00 on an initial investment of $1.50. This represents a 666% return on initial investment. As you can see the potential yield is six times the potential risk.
Regarding your risk, it is also limited. Suppose XYZ reaches to $100 per share. In this case you would sell your option at $60.00 May 40, and your call May 60 to $40.00. That's $100.00 from the sale of two options where you are in the position to purchase. However, you should also adjust your short position on stock options May 50, which would cost you $50.00 each, so a total of $100.00 to close positions. Both positions will therefore eliminate each other, except for the initial investment of $1.50. The total loss if the stock were to rise is thus $1.50.
The situation is the same whether the action period ends below $40.00. At any price below $40.00, all options expire and are worth nothing. Again, your maximum loss is then $1.50 per share.
The disadvantage of this type of options strategy is the operation costs. Professional traders on the stock market can use this type of strategy to their advantage because their transaction costs are very low. But this means that negotiators must perform three operations to establish the position, and possibly three operations to get out. If you add the cost of the six operations in the equation, your potential profit margin narrows considerably.