Butterfly options involve using a series of long and short calls to minimize the risk of loss and improve chances of earning a modest return. There are two types: long butterfly and short butterfly. Timing and option selection are crucial for success.
Butterfly options are options involved in an investment strategy that is structured to provide a limited amount of returns even if the degree of risk associated with the underlying assets of the options should change in the future. The process involves using a series of long and short calls to create a pattern that helps insulate the investor from incurring losses, even if the implied risk associated with the options is different from the future risk that eventually emerges. As with many option strategies, structuring butterfly options requires careful planning, selection, and attention to detail to be successful.
There are actually two different types of butterfly options. One is known as the long butterfly. With this agreement, all the options involved will have the same expiration date. The series of calls will involve a long call that has a strike price that is slightly lower than the benchmark, followed by two short calls at the benchmark. As the final stage of the process, a long call is initiated at a price slightly above the strike price. The combination helps offset the chance of loss overall, allowing the investor to effectively minimize the chances of loss, while helping to improve the chances of earning at least a modest return.
Short butterfly options also use a series of calls or sometimes a combination of put and call to produce the desired result. The difference is that with a short butterfly approach, the combination of short and long calls is reversed, which means that when long calls are used in the long butterfly, the short calls are substituted. At the same time, the short calls in the long butterfly are replaced with long calls in the short butterfly approach. This arrangement, assuming ideal option selection, is more likely to produce income if the future volatility of the options is greater than the implied volatility.
The timing of butterfly options is very important for the success of the strategy. In addition to choosing the right options, it is key that changes in volatility are observed throughout the process and that each of the calls involved is initiated at the right time. While somewhat complicated, this approach is capable of generating returns that make the time and effort worthwhile for many investors. Newer investors typically only try this approach by working closely with an experienced broker who is able to identify the right mix of options and can also advise on the timing of each call.
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