The Option Profit

BUTTERFLY & CONDOR

A butterfly spread consists of 4 trades using three strike prices, with one strike higher, one strike lower and two in the middle with the same strike. All strikes share the same expiration date. The condor is similar but the two middle positions have different strikes.

To enter into a traditional butterfly call spread an investor would buy a higher strike call contract, buy a lower strike call contract, then sell two call contracts of the same strike in the middle. To enter into a text book butterfly put spread, an investor would buy a higher strike put contract, buy a lower strike put contract, then sell two put contracts with the same strike in the middle. A condor transaction would follow the same principal with the middle contracts having separate strikes. With this strategy an investor would enter in the trade with the expectation that the underlying will close at or near the middle strike price. Typically, this strategy will have a minimum cost and offers potential for a minimum return with little risk. The investor will know both the highest possible return and the maximum potential loss at execution.

The Option Profit team will also utilize a modified version of the butterfly spread where an investor would buy the middle two strike price contracts and sell the higher and lower strike contracts. In this strategy, an investor would enter into the trade with the expectation that the underlying will close above the higher strike or below the lower strike. The premium received would equal the maximum potential gain. The maximum potential loss would be the difference between the top or bottom strike and the middle strikes minus the premium received. Below are hypothetical examples of each and how they would benefit an investor assuming XYZ is at 100.

The Math: Traditional Butterfly

Anticipating XYZ will close at or near 105, an investor would buy a May 100 call for $6, buy a May 110 call for $1 then sell 2 May 105 calls for $3 each for a total cost of $1, the maximum potential loss. On expiration, if XYZ closes at 105, the investor would realize the maximum gain of $4, which decreases as XYZ moves away from the middle strike price in either direction.

@ 100 all expire worthless - $1 premium = $1 loss
@ 105 100 call = $5 gain - $1 premium paid = $4 gain
@ 110 100 call = $10 gain - $10 105 call loss - $1 premium = $1 loss

The Math: Modified Butterfly

Anticipating XYZ will close above 100 or below 90 an investor would sell a May 100 put for $6 and a May 90 put for $1 then buy 2 May 95 puts for $3 each realizing a $1 premium, the maximum potential return. The potential for loss = $4 as the underlying moves towards 95.

@ 100 all expire worthless and $1 premium is realized
@ 95 100 put = $5 loss + $1 premium = $4 loss
@ 90 100 put = $10 loss + $10 gain on 95 puts + $1 premium = $1 gain

The Math: Condor

An investor would buy May 100 call for $6 and May 110 call for $1, then sell a May 105 call for $3.50 and a May 106 call for $2.50, anticipating more volatility and allowing for a larger window to realize a potential $4 profit. The potential loss is $1, the cost of the purchases minus the premium received from the sells. If, at expiration, XYZ closes between 105 - 106 the investor realizes the maximum gain declining as the underlying moves away in either direction.

@ 105, 100 call = $5 gain - the $1 premium paid = $4 gain
@ 106, 100 call = $6 gain - 105 call $1 loss - $1 premium paid = $4 gain
@ 110, 100 call = $10 gain - $5 105 loss - $4 106 loss -$1 premium loss = 0

Refer to Glossary for terms and definitions

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RISK is inherent in any investment. No individual or entity should invest with funds they cannot afford to lose. Option trading is time sensitive and involves risk including, but not limited to, loss of gains and principal. A leveraged investor risks the loss of more than principal. Options do not have to be held until expiration and can be exercised at any point. Option trades can be closed prior to expiration with a gain or loss being realized. It is important that you understand all trades and the risk associated before executing a transaction. The Option Profit provides broad ideas, not individual recommendations, and is not responsible for any losses incurred. Diversification is important with any strategy and should be considered when investing Before trading consult with a financial advisor to determine if option trading is appropriate for you and your financial goals.