2 Advanced Options Trading Strategies with Butterfly Spreads

Options trading is a popular form of derivative trading that requires traders to purchase an options contract. The contract gives traders the right, but not the obligation, to buy or sell a set amount of an asset, at a predetermined price, on a predetermined day.

If you are an intermediate options trader, you may want to take up new strategies and finetune your trading knowledge and expertise. In that case, read on. In this article, we will revisit why people trade options and offer some advanced trading strategies that involve the use of butterflies.

Why trade options?

Options are popular for several reasons, ranging from flexibility to the potential to generate large profits. Below, let us take a quick look at why people trade options.

Big variety of instruments and markets

The first reason why people trade options is because of the large variety of instruments and markets they can gain access to. Options traders are free to trade equity, commodity, forex, and index options – and more, depending on the provider or broker they work with. This makes it very easy for traders to participate in new markets and diversify their portfolio.

Use of leverage

When trading options, traders have access to leverage. The use of leverage is when a trader borrows capital from their broker or bank to open a larger position than they could otherwise have done with their existing funds. Traders may use leverage to increase their market exposure, so that if the markets do go their way, they can potentially make much bigger profits.

However, leverage goes both ways, and traders can also much greater losses than anticipated. Therefore, it is crucial to use leverage with caution and trade more than you can afford to lose.

Flexibility

Finally, traders buy options contracts instead of assets directly because of the flexibility these contracts offer. When trading options, traders are not bound to their positions after paying a small sum (called a premium) for their contract. If the markets go against their initial predictions, they can simply ‘abandon’ their contract and only lose the premium they pay. If markets are performing favourably, traders can choose to execute what is stipulated in their contract.

What are butterfly options strategies?

If you are unfamiliar with the use of the butterfly in trading options, also called the butterfly spread, let us revisit it.

The butterfly spread is a neutral option strategy that mainly aims to reduce the risk traders take on when they trade. Many traders use the butterfly in relatively stable markets. To set up a butterfly spread, a trader combines bull and bear spreads with strike prices in a profit-loss graph that resembles a butterfly’s pair of wings.

Due to the need to buy and sell several options contracts in one go, many traders find the butterfly spread more complicated than your average strategy. The use of the butterfly certainly requires more precision in timing, and the primary goal traders want to achieve is to strike a balance between risk and reward when they have market predictions.

2 advanced strategies with butterfly spreads

When it comes to using butterfly spreads, there are plenty of options available, from long butterflies with calls or puts to iron butterflies. Today, we take a look at Skip Strike Butterflies with Calls and Puts, from when traders use them to how to set them up.

Skip Strike Butterfly with Calls

Some traders call the skip strike butterfly strategy the ‘broken wing’ or ‘split strike butterfly’ due to the imbalance of ‘winged’ pattern in its profit-loss graph. Traders use it when they are slightly bullish, and they want the price of the asset to rise slightly.

To set up this strategy, you buy a call at Strike Price A. You then sell two calls at Strike Price B, skip over Strike Price C, and finally, buy a call at Strike Price D. The current asset price will be at or below Strike Price A. All your contracts should have the same expiry month.

There is slightly more risk when setting up a skip strike butterfly compared to a traditional butterfly spread. This is because there is a narrower profit-taking spot, and the extra short call spread creates a bit more risk. Ideally, when a trader employs this strategy, they want the asset price to rise slightly and reach Strike Price B when the contract reaches expiry, but not further than that.

Skip Strike Butterfly with Puts

Next is the same strategy, using Puts. Some traders call this the ‘broken wing’ or ‘split strike butterfly’ as well. Traders use it when they are slightly bearish, and they want the asset price to decrease slightly.

To set up this strategy, you do the reverse of the Call Skip Strike. In other words, you buy a put at Strike Price A first. You then skip over Strike Price B. Afterwards, you sell two puts at Strike Price C, and you finally buy a put at Strike Price D. The current asset price will be at or above Strike Price D, and ideally, when you employ this strategy, you want the asset price to fall slightly and reach Strike Price B.

Again, all your contracts should have the same expiry month.

Right away, a trader can visualise that this strategy is the inverse of the previous one, and that it contains a different ‘broken wing’. This means there is also slightly more risk when setting up this skip strike butterfly compared to the traditional butterfly spread, for a similar reason. The extra short put spread creates the extra bit of risk.

A tip when trading the butterfly spread

As traders use butterfly spreads most when there is little movement in the market, it may be more appropriate for them to trade index options when applying this strategy. This is because indices tend to be less volatile than individual stocks. However, if you are confident in the performance of a single stock you would like to trade, the butterfly spread will work just the same.

Why trade butterfly spreads?

Trading butterflies can be beneficial to traders who operate with limited capital. This is because the use of butterfly options can secure market exposure while limiting the amount of risk and liabilities a trader will carry. Traders also do not need a vast amount of money due to the simultaneous combination of buying and selling.

The bottom line

If you are on the fence when it comes to this strategy, you are not alone! Advanced options trading strategies are not for everyone, and spreads are one of the most confusing areas of derivative trading in financial markets. Their intricacies can be a turn-off, and others may prefer sticking to simpler strategies with the same (or sometimes greater) pay-off.

At the end of the day, if you do choose to trade with butterfly spreads, you should be certain that you understand the strategies thoroughly before entering the markets. Remember that all trading contains risks – even with the use of risk-limiting strategies. You should also make sure you understand the margin requirements for each butterfly strategy, the expiry dates of your contracts, and the impact of time decay in options trading.

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