2.Butterfly Strategy - Let Profits Soar Like a Butterfly

Hello

Welcome to Tiger Academy - 「Options Advanced Strategy」episode 2.

In our previous discussion, we covered the Ratio Spread Strategy, which emphasizes stability but comes with two drawbacks: firstly, one must hold the position until expiration to realize the expected premium income, and secondly, the profit potential is limited. Is there a strategy that allows us to limit minor losses while increasing potential profits?

Many may immediately think of directly engaging in single-leg options, either as a call or put buyer, since being a buyer inherently entails limited losses and unlimited gains.

However, Tiger Academy wants to convey to everyone that this statement itself is a fallacy because it overlooks the win rate, focusing only on the asymmetry between losses and gains.

For instance, if an investor implements the long call strategy 100 times, with a premium expense of $1 each time, and experiences a complete loss of the premium in 99 instances (yielding a -100% return each time), but succeeds once with a 2000% return (earning $20), the net result is still a loss of $79. Calculating based on an initial investment capital of 100, the overall return for these 100 trades is -79%.

Therefore, the cost of having limited losses and unlimited gains as a buyer is an exceptionally low win rate. Tiger academy does not recommend such an approach, especially when market expectations for future stock prices are uncertain.

We need a strategy that significantly increases the win rate and profit range, while incurring only minor losses in case of an error. This is precisely what we are introducing today – the butterfly strategy.

1. What is the Butterfly Spread Strategy?

The Butterfly Spread Strategy involves selecting a high strike price and a low strike price, then determining a middle strike price between them. One sells a call option at the high strike price, another at the low strike price, and simultaneously buys two call options at the middle strike price, forming a step-like combination of four call options.

For example, selling an Apple call option at $185 and another at $195, while buying two call options at $190, creates a Butterfly Spread call option strategy. How does this operation generate profits?

2. Butterfly Spread Strategy Profit and Loss

Firstly, the combination will generate a net premium income of $2.09 (6.56+0.33-2*2.4). Secondly, based on subsequent stock price movements, there will likely be the following profit and loss scenarios:

1. Stock price falls below $185: In this scenario, the call options sold at $185 and $195 will not be exercised, resulting in a net gain of $6.89. The two call options bought at $190 will not be exercised either, leading to a net loss of $4.8. The overall combination ends up with a net gain of premium income of $2.09.

2. Stock price rises above $195: In this case, the call options sold at $185 and $195 will be exercised, causing a loss. The call option bought at $190 will be exercised, resulting in a profit. The final outcome offsets each other, and the combination ultimately has a net gain of premium income of $2.09.

3. Stock price is between $185 and $195: The lowest point of profit in this scenario occurs at the $190 strike price. Firstly, the call option sold at $185 will be exercised, incurring an exercise loss of $5. Secondly, the two call options bought at $190 will not be exercised, and the call option sold at $195 will not be exercised either. Therefore, the combination's net premium income remains $2.09 (6.56+0.33-2*2.4), resulting in a final net loss of $2.98 ($5-2.09).

4. The breakeven points for the combination occur at $187.09 and $192.98, where the stock price between these points results in a loss for the combination, and outside this range, the combination is profitable.

In summary, we can directly plot the profit and loss graph for this strategy.

According to the profit and loss graph, we can observe that the butterfly strategy has a wide profit range. In other words, the length of the loss range is only about 5 units. The greater the stock price volatility, the higher the success rate of this strategy. Furthermore, even if it falls within the loss range, the maximum loss of $2.98 is much smaller than the premium loss under a single-leg option.

Astute readers will notice that the profit graph of this strategy is similar to the straddle strategy introduced by Cheese Tiger earlier. The only difference is that the profit graph of the straddle strategy forms a complete "V" shape. Additionally, the maximum loss of the straddle strategy is likely greater than that of the butterfly strategy, and its profit range is smaller (lower success rate). However, the advantage of the straddle strategy is that its potential profit is theoretically unlimited.

Of course, if our expectations are opposite, anticipating minimal future stock price changes while wanting to limit minor losses, we can implement the reverse butterfly strategy. Using the previous example, we would need to buy call options with strike prices of $185 and $195 and sell two call options with a strike price of $190. In this case, the profit and loss would be reversed compared to the previous example.

Alright, that's it for today's content. If you find this article helpful, feel free to like and share. You will earn Tiger Coins!

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