A butterfly is a neutral, income-oriented strategy. It is a limited risk and limited profit trade, but on a typical butterfly trade, the profit potential is higher than the potential loss.
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Butterfly spreads involve three different option strike prices, all within the same expiration date. They can be created using either calls or puts.
A typical butterfly would be constructed as follows:
- Buy 1 in-the-money call
- Sell 2 at-the-money calls
- Buy 1 out-of-the-money call
Today, we will look at an example on Apple (AAPL) stock:
- Buy 1 July 21, 160 call @ 18.05
- Sell 2 July 21, 175 calls @ 6.60
- Buy 1 July 21, 190 call @ 0.90
The total cost of this trade was $575 using quotes from late Friday. And that is the maximum loss potential on the trade.
Maximum Gain on Apple Stock Trade $925
The maximum gain is $925, which is calculated by taking the difference in strike prices less the premium paid ($1,500 less $575).
The break-even prices are 165.75 and 184.25 (the lower strike plus the premium, and upper strike minus the premium).
A butterfly options trade, has a tentlike shape with the potential for very large profits around the short strike. It’s important to keep in mind that it’s unlikely you would ever achieve the maximum profit.
A good aim for a butterfly trade is to make a 20% return on capital at risk. In this case that would be around $115.
According to the IBD Stock Checkup, Apple stock is ranked No. 2 in its industry group, and has a Composite Rating of 92, an EPS Rating of 80 and a Relative Strength Rating of 89.
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Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
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