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:
- Sell two middle-range calls and buy two calls, one with a striking price above that level and one with a striking price below that level.
- Sell two middle-range puts and buy two puts, one with a striking price above that level and one with a striking price below that level.
- Buy two middle-range calls and sell two puts, one with a striking price above that level and one with a striking price below that level.
- Buy two middle-range puts and sell two puts, one with a striking price above that level and one with a striking price below that level.
ExampleThe Butterfly in Flight: You sell two September 50 calls at 5, receiving $1,000.
Smart Investor TipExotic 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.
ExampleNetting 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.
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.[/caption]
A detailed butterfly spread, with defined profit and loss zones, is shown in Figure above. In this example, the following transactions are involved:
- Sell two June 40 calls at 6 (+$1,200).
- Buy one June 30 call at 12 (-$1,200).
- Buy one June 50 call at 3 (-$300).
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
|Price||June 30||June 40||June 50||Total|
|50||+ 800||- 800||- 300||- 300|
|49||+ 700||- 600||- 300||- 200|
|48||+ 600||- 400||- 300||- 100|
|47||+ 500||- 200||- 300||0|
|46||+ 400||0||- 300||+ 100|
|45||+ 300||+ 200||- 300||+ 200|
|44||+ 200||+ 400||- 300||+ 300|
|43||+ 100||+ 600||- 300||+ 400|
|42||0||+ 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||- 300||0|
|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.