Unintentional Butterfly Spreads

Butterflies are a very popular option trading strategy among  individual investors.  I seldom trade butterflies, but because of my style, I often find that I own flys (a convenient abbreviation).  The question arises: How can I take advantage of owning those unintentional butterflys, or should I pretend they are not part of my account?

A butterfly is a spread with three legs.  All three are calls, or all three are puts, and each expires at the same time.  A call butterfly combines the purchase of a bull spread with the sale of a bear spread of equal width [If the bull spread is 5-points wide, then so is the bear spread], with the proviso that the option sold in each spread is identical.

The ratio for a butterfly is: long one; short two; long one.

Here's a butterfly spread that I held last week:

Long  12 RUT Jun 540 calls
Short 24 RUT Jun 550 calls
Long  12 RUT Jun 560 calls

Note this position is

Long  12 RUT Jun 540/550 call spreads
Short 12 RUT Jun 550/560 call spreads

There are other types of butterfly spreads, including iron butterflies and broken-wing butterflies.  Perhaps that's a good topic for another post.

Unintentional?  How can I own an unintentional position?

I trade iron condors most of the time.  Last week I was still holding onto some June positions, against my better judgment. [But this time I got lucky and earned a good profit.  More often than not, I find holding these risky positions results in further losses.]

I had two June call spreads remaining, having recently covered the put spread portion of the iron condors at low prices.  I was short the Jun 530/540 call spread and the Jun 550/560 call spread.  Here is a list of my positions (but not using the correct quantities):

Short 20 RUT Jun 530 calls
Long  26 RUT Jun 540 calls  (I owned six extra calls)
Short 25 RUT Jun 550 calls
Long  25 RUT Jun 560 calls

Embedded in those two call spreads are two butterflys. 

I was long 12 RUT Jun 540/550/560 call butterflys (12x24x12)

I was also short 12 RUT Jun 530/540/550 butterflys.

I refer to these positions as unintentional butterflies because I did not originate the positions as flies, but as individual call spreads.  Nevertheless, those butterflies were in my portfolio.

If RUT were to rally to 550, the butterfly spread would be a winner.  But that's not the way to evaluate risk because the 530/540 spread would lose the maximum possible amount, and my six extra calls would only help (up to 550) on a continued rally.

Above 550, I'd be facing immediate danger from the 550/560 spread.  Six extra longs don't go very far when protecting a short position of 25 spreads.

NOTE:  Looking at values when expiration arrives, at 550, the six extra calls would be worth $1,000 apiece.  Because I was short 25 Jun 550 calls (and still long six 540s), for each point above 550, I'd lose $1,900 – up to a maximum of $19,000.  After 560 the losses stop and my six extra calls would produce $600 per point.  But this is a very risky position when RUT is trading that high.  the position was bad enough at 530, but I did not want to face that trouble if we rallied far above 550.

Thus, I sold my call butterfly spreads.  My rationale was that it reduced risk if we rapidly rose above 550 (yes, I understand if that happened I could sell the fly at a better price as the index approached 550), and would provide extra profits if RUT ended its rally and headed lower.  The point of this story is that I had a butterfly embedded in my position and made a trade it when I thought the price was good enough ($1.30). 

The position looked strange after the trade, but was still easy to manage.  As it turned out this time, the market receded and the June positions were readily closed.

Position after butterfly sale:

Short 20 RUT Jun 530 calls
Long  14 RUT Jun 540 calls
Short   1 RUT Jun 550 call
Long  13 RUT Jun 560 calls

When you own flies, the best result occurs when expiration arrives and the underlying asset is very near the middle strike.  Then the bull spread (you bought) is worth near its maximum value and the put spread (you sold) is worthless (or worth very little).

Thus, holding has benefits.  The spread can continue to increase in value.

But, holding is risky because if the market moves and the three options are out of the money (or in the money) at expiration, then the fly is worthless.  Thus, it's best to sell a fly at some point.  But choosing that point is a difficult proposition.  I'm sure some fly traders have their individual guidelines, but I was pleased to collect that $1.30 with a week and a half remaining before the options expired – and especially when all the options were OTM at the time I sold the fly.

If you have
more than one iron condor position for any given expiration month,
take a look the possibility (don't jump in without a good understanding of how to handle the residual position) of trading those embedded flys for additional
profit opportunities.

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2 Responses to Unintentional Butterfly Spreads

  1. kbluck 06/18/2009 at 10:49 AM #

    On a tangentially related note, for traders who like to adjust their IC wings outward when one is threatened, buying a butterfly is often a convenient way of doing so. Of course, this is a debit trade, but if you’re comfortable with the cost and the resulting position it’s a nice little trick to know about.
    As an illustration for the audience, suppose you have an IC at strikes 400/420/580/600. You might have a trading rule that if the market price touches 580, you will buy a butterfly to roll the call wing out. In this case, buying a 580/600/620 call butterfly will leave you net an IC at 400/420/600/620. Naturally, the same thing could be done to roll down the put wing.

  2. Mark Wolfinger 06/18/2009 at 11:02 AM #

    Thanks. Good point.
    I’ve used this type of adjustment. The problem is that when (in your example) RUT is trading at the strike price (580), that butterfly is costly – making it difficult for some to pull the trigger on the trade.
    And, although I do like the idea, when RUT is 580 is it a good idea to spend cash on that butterfly to move your call spread so that it’s only 20 points (3%) out of the money? There is no correct answer because that’s a comfort zone decision.
    For those who like the idea of adjusting earlier (as many do), and especially if you adjust in stages, this butterfly can be purchased when RUT is 560. It’s an earlier adjustment, doesn’t have to be performed on the entire position, and the butterfly costs less.
    This is a very flexible strategy.
    Thanks for the reminder.