Ideally, you want the puts with strikes A and B to expire worthless, while capturing the intrinsic value of the in-the-money put with strike C.
Because you’re selling two options with strike B, butterflies are a relatively low-cost strategy. So the risk vs. reward can be tempting. However, the odds of hitting the sweet spot are fairly low.
Constructing your butterfly spread with strike B slightly in-the-money or slightly out-of-the-money may make it a bit less expensive to run. This will put a directional bias on the trade. If strike B is higher than the stock price, this would be considered a bullish trade. If strike B is below the stock price, it would be a bearish trade. (But for simplicity’s sake, if bullish, calls would usually be used to construct the spread.)
Maximum Potential Profit
Potential profit is limited to strike C minus strike B minus the net debit paid.
Maximum Potential Loss
Risk is limited to the net debit paid.
Break-even at Expiration
There are two break-even points for this play:
- Strike A plus the net debit paid.
- Strike C minus the net debit paid.
TradeKing Margin Requirements
After the trade is paid for, no additional margin is required.
As Time Goes By
For this strategy, time decay is your friend. Ideally, you want all options except the put with strike C to expire worthless with the stock precisely at strike B.
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast was correct and the stock price is at or around strike B, you want volatility to decrease. Your main concern is the two options you sold at strike B. A decrease in implied volatility will cause those near-the-money options to decrease in value, thereby increasing the overall value of the butterfly. In addition, you want the stock price to remain stable around strike B, and a decrease in implied volatility suggests that may be the case.
If your forecast was incorrect and the stock price is approaching or outside of strike A or C, in general you want volatility to increase, especially as expiration approaches. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike B, thereby increasing the overall value of the butterfly.