Strategies with a Middle Range

Another technique calls for the opening of offsetting options in middle striking price ranges, with opposing positions above and below. When options strategies are designed to create maximum advantages in periods of price consolidation for the stock, they are referred to as sideways strategies. The most popular of these is known as the butterfly spread. It can involve long and short positions in calls or puts. There are several possible variations of the butterfly spread. For example:


The Butterfly in Flight: You sell two September 50 calls at 5, receiving $1,000.
You also buy one September 55 call at 1 and one September 45 call at 7, paying a total of $800. Net proceeds are $200. This is a credit spread, since you receive more than you pay. You will profit if the underlying stock's price falls. And no matter how high the stock's price rises, the combined long positions' value will always exceed the values in the two short positions.

Smart Investor Tip

Exotic combinations are more often good for studying strategy than for actual use in the market. Trading costs are likely to offset potential limited profits in such strategies.

Butterfly spreads often are created when a single open position is expanded by the addition of other calls or puts, most often to protect a short position when a stock moves in a direction other than anticipated. It is difficult to create situations with risk-free combinations such as the one in the previous example.


Netting the Butterfly: You sold two calls last month with a striking price of 40. The underlying stock's market value has declined to a point that the 35 calls are cheap, so you buy one to partially cover your short position. At the same time, you also buy a 45 call, which is deep out of the money. This series of trades creates a butterfly spread.

Trading costs makes butterfly spreads impractical when using a small number of options. The potential gain should be evaluated against the potential loss, trading costs, and ongoing exposure to risk.

Butterfly spreads involve either calls or puts. A bull butterfly spread will be most profitable if the underlying stock's market value rises, and the opposite is true for a bear butterfly spread.

[caption id="attachment_12569" align="aligncenter" width="300"]Butterfly spread profit and loss zones. Butterfly spread profit
and loss zones.[/caption]
A detailed butterfly spread, with defined profit and loss zones, is shown in Figure above. In this example, the following transactions are involved:

The net cost is $300. This butterfly spread will either yield a limited profit or result in a limited loss. The potential yield often does not justify the strategy, since trading costs will not offset the limited potential profit. That is why the butterfly spread is often created in increments rather than all at once. Instead of executing the trades in the example, it might be more practical to simply buy one June 50 call and pay $300. In that alternative, you still have a limited potential loss ($300) but you also gain unlimited profit potential.

Table below summarizes profit and loss status at various prices of the underlying stock, using the previous example. It is based on values at expiration and assumes no remaining time value. If the stock's market value rises to $50 or more, the short position losses will be offset by an equal number of long position profits. And if the stock's market value declines, the maximum loss is $300, the net cost of opening these positions.

Profits/Losses for Butterfly Spread Example

PriceJune 30June 40June 50Total
$51+ $900-$1,000-$200-$300
50+ 800- 800- 300- 300
49+ 700- 600- 300- 200
48+ 600- 400- 300- 100
47+ 500- 200- 3000
46+ 4000- 300+ 100
45+ 300+ 200- 300+ 200
44+ 200+ 400- 300+ 300
43+ 100+ 600- 300+ 400
420+ 800- 300+ 500
41- 100+ 1,000- 300+ 600
40- 200+ 1,200- 300+ 700
39- 300+ 1,200- 300+ 600
38- 400+ 1,200- 300+ 500
37- 500+ 1,200- 300+ 400
36- 600+ 1,200- 300+ 300
35- 700+ 1,200- 300+ 200
34- 800+ 1,200- 300+ 100
33- 900+ 1,200- 3000
32-1,000+ 1,200- 300- 100
31-1,100+ 1,200- 300- 200
30-1,200+ 1,200- 300- 300
29-1,200+ 1,200- 300- 300
Lower-1,200+ 1,200- 300- 300

A variation on the butterfly is the condor spread. This is similar to the butterfly because it contains a bull and bear spread in combination; but with the condor, the striking prices of the short call and short put are not identical.

A similar variation on the use of multiple options is the strap. Also called a triple option, the strap consists of one long put and two calls (or vice versa). When the calls outnumber the puts, the position benefits if and when the underlying stock's market value rises. When the reverse is true, the position will benefit when the stock value declines. Because the in-the-money value of the heavier position will grow by two points, a favorable movement will quickly outpace the position cost. If the stock's price moves in the opposite direction, the single offsetting option will partially offset the cost (and if price movement is severe enough, it could recapture the entire cost).

In some brokerage account arrangements, you can reduce your trading cost by arranging for a multileg options order. This applies when several option positions are going to be opened at the same time, and the orders will be placed for a single commission rather than being charged a fee on each option position.

Any combination involving separate or offsetting options can be designed so that profits will be taken at specific points, either using stop orders or through careful tracking of the combination's status. However, in taking partial profits, you should be careful to not expose yourself to unintended risks. For example, if a short position is protected by an offsetting long position, the risk is minimal. But if the long position is closed without also closing the short position, additional risk is created.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2020. Content published with author's permission.

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