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Saturday, April 16, 2011

How To Use Short Butterfly Spread

How To Use Short Butterfly Spread : There are 3 option trades to establish for this strategy : 1. Sell To Open X number of In The Money Call Options. 2. Sell To Open X number of Out Of The Money Call Options. 3. Buy To Open 2X number of At The Money Call Options.

Veteran or experienced option traders would identify at this point that the short butterfly spread actually consists of a Bear Call Spread and a Bull Call Spread. This is similar to a Short Condor Spread except for the fact that the middle strike price has been combined into 1 same middle strike price.

The choice of which strike prices to Sell the short legs (trades 1 and 2 above) at depends on how volatile and how strongly the stock is expected to swing. The further away the two short legs are, the higher the maximum profit and the further the stock needs to move in one direction in order to reach breakeven.

Interestingly, the Short Butterfly Spread can also be executed by using Put Options instead of Call Options with the same effects. We will use Call Options as the standard example here.

Example : Assuming QQQQ trading at $43.57.

Sell To Open 1 contract of Jan $42 Call at $2.38
Sell To Open 1 contract of Jan $44 Call at $1.06
Buy To Open 2 contracts of Jan $43 Call at $1.63.

Net Credit = (($1.63 - $1.06) + ($1.63 - 2.38)) x 100 = $18.00 per position
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