What Is the Modified Butterfly Spread?

A modified butterfly spread is an options strategy that adjusts a standard butterfly's strike prices or contract ratios to achieve a specific market outlook. Also called the 1-3-2 butterfly spread, it is a common variation if the butterfly spread involving buying one option at a lower strike, selling three at a middle strike, and buying two at a higher strike. This advanced options trading strategy offers more flexibility.

Understanding the Basic Butterfly Spread

Before looking at the modified version of the butterfly spread, let's quickly review the basic butterfly spread. Most individuals who trade options start simply buying calls and puts to leverage a market timing decision, or perhaps writing 澳洲幸运5官方开奖结果体彩网:covered calls to generate income. Interestingly, the longer a trader stays in the options trading game, the more likely they are to migrate away from these two most basic strategies and delve into strategies that offer unique op🎃portunities.

One strategy that is quite popular among experienced options traders is known as the 澳洲幸运5官方开奖结果体彩网:butterfly spread. This strategy allows a trader to enter into a trade with a high probability of profit, high-profit potential, and 澳洲幸运5官方开奖结果体彩网:limited risk.

The basic butterfly can be entered using calls or puts in a ratio of 1 by 2 by 1. This means that if a trader is using calls, they will buy one call at a particular 澳洲幸运5官方开奖结果体彩网:strike price, sell two calls with a higher strike price, and buy one more calܫl wi♉th an even higher strike price. When using puts, a trader buys one put at a particular strike price, sells two puts at a lower strike price, and buys one more put at an even lower strike price.

Typically the strike price of the option sold is close to the actual price of the 澳洲幸运5官方开奖结果体彩网:underlying security, with the other strikes above and below the 澳洲幸运5官方开奖结果体彩网:current price. This creates a "neutral" trade whereby the trader makes money if the underlying security 🍎remains within a particular price range above and below the current price. However, the basic butterfly can also be used as a directional trade by making two or more of the strike prices well beyo𓆉nd the current price of the underlying security.

Figure 1 displays the 澳洲幸运5官方开奖结果体彩网:risk curves for a standard 澳洲幸运5官方开奖结果体彩网:at-the-money, or neutral, butterfly spread. Figure 2 displays the risk curves for an 澳洲幸运5官方开奖结果体彩网:out-of-the-money butterfly spread using call options.

Source: Optionetics Platinum

Source: Optionetics Platinum

Both of the standard butterfly trades shown in Figures 1 and 2 enjoy a relatively low and fixed-dollar risk, a wide range of profit potential, and the possibility of a high 澳洲幸运5官方开奖结果体彩网:rate of return.

Understanding the Modified Butterfly Spread

The modified butterfly spread is different from the basic butterfly spread in seve🙈ral im๊portant ways:

1. Puts are traded to create a bullish trade and calls are traded to create a bearish trade.
2. The options are not traded in 1:2:1 fashion but rather in a ratio of 1:3:2.
3. Unlike a basic butterfly with two 澳洲幸运5官方开奖结果体彩网:breakeven prices and a range of profit potential, the modified butterfly has only one breakeven price, typically out-of-the-money. This creates a cushion for the trader.
4. One negative associated with the modified butterfly versus the standard butterfly: While the standard butterfly spread almost invariably involves a favorable 澳洲幸运5官方开奖结果体彩网:reward-to-risk ratio, the modified butterfly spread almost invariably incurs a great dollar risk compared to the maximum profit potential. Of course, the one caveat here is that if a modified butterfly spread is entered properly, the underlying security would have to move a great distance in order to reach the area of maximum possible loss. This gives alert traders a lot of room to act before the worst-case scenario unfolds.

Figure 3 displays the risk curves for a modifi﷽ed butterfly sꦡpread. The underlying security is trading at $194.34 a share. This trade involves:

• Buying one 195 strike price put
• Selling three 190 strike price puts
• Buying two 175 strike price puts

Source: Optionetics Platinum

A good 澳洲幸运5官方开奖结果体彩网:rule of thumb is to enter a modified butterfly four to six weeks🏅 before option expiration. As such, each of the options in th📖is example has 42 days (or six weeks) left until expiration.

Note the unique construction of this trade. One at-the-money put (195 strike price) ꦚis purchased, three puts are sold at a strike price that is five points lower (190 strike price) and two more puts are💜 bought at a strike price 20 points lower (175 strike price).

There are several key things to no💫te about this trade:

1. The current price of the underlying stock is 194.34.
2. The 澳洲幸运5官方开奖结果体彩网:breakeven price is 184.91. In other words, there are 9.57 points (4.9%) of 澳洲幸运5官方开奖结果体彩网:downside protection. As long as the underlying security does anything besides declining by 4.9% or more, this trade will show a profit.
3. The maximum risk is $1,982. This also represents the amount of capital that a trader would need to put up to enter the trade. Fortunately, this size of loss would only be realized if the trader held this position until expiration and the underlying stock was trading at $175 a share or less at that time.
4. The maximum profit potential for this trade is $1,018. If achieved this would represent a return of 51% on the investment. Realistically, the only way to achieve this level of profit would be if the underlying security closed at exactly $190 a share on the day of option expiration.
5. The profit potential is $518 at any stock price above $195—26% in six weeks.

Key 💧Criteria to Consider in 🅰Selecting a Modified Butterfly Spread

The three key criteria to look at when considering a modifiedꦆ butterfly spread are:

1. Maximum dollar risk
2. Expected percentage return on investment
3. Probability of profit

Unfortunately, there is no optimum formula for weaving these three key criteria together, so some interpretation on the part of the trader is invariably involved. Some may prefer a higher potential rate of return while others may place more emphasis on the probability of profit. Also, different traders have different levels of 澳洲幸运5官方开奖结果体彩网:risk tolerance. Likewise, traders with larger accounts are better able toಞ accept trades with a higher maximum potential loss than traders with smaller accounts.

Each potential trade will have its own unique set of reward-to-risk criteria. For example, a trader considering two possible trades might find that one trade has a probability of profit of 60% and an 澳洲幸运5官方开奖结果体彩网:expected return of 25%, while the other might have a probability of profit of 80% but an expected return of only 12%. In this case, the trader must decide whether☂ they put more emphasis on the potential return or the likelihood of profit. Also, if one trade has a much greater maximum risk/capital requirement than the ot🐻her, this too must be taken into account.

Advantages of a Modified Butterfly Spread

One key advantage is the ability to adjust the strike prices or the ratio of options contracts to better align with market exp💙ectations. For example, the 1-3-2 butterfly spread skews the risk-reward profile in favor of a particular directional bias. By doing so, traders can target a broader range of profitable outcomes compared to the symmetrical structure of a standard butterfly spread.

Another significant advantage is the potential for an improved 澳洲幸运5官方开奖结果体彩网:risk-reward ratio. In a standard butterfly spread, the profit zone is narrow and centered around a single strike price. However, a modified butterfly spread can be tailored to either widen this zone or shift it toward a more faඣvorable price range.

The modified butterfly spread also benefits from the efficient use of capital. Since the strategy involves buying and selling options with offset👍ting risk profiles, the margin requirements are typically lower than other ꦚmulti-leg strategies with similar risk characteristics.

Last🐠, unlike a standard butterfly where the options are typically left to expire, a modified version offers more opportunities for active management. Traders can roll the spread to a different strike or expiration, or they can close specific legs to loไck in profits or reduce losses. This dynamic nature gives traders a level of flexibility that is not available in more rigid strategies.

Challenges of Modified Butterfly Spread

One of the primary challenges is the increased structural complexity. Modifying the standard butterfly into something like the 1-3-2 butterfly spread complicates the position's risk and reward dynamics. These modifications require a more sophisticated understanding of options pricing, delta, and gamma.

Another downside is the potential reduction in the risk-reward efficiency of the strategy. Modifications that widen the profit zone or shift the breakeven points often come at the cost of a lower maximum profit. This is true in modified butterfly structures like the 1-3-2 butterfly spread. Whil✅e this trade-off may provide a higher probability of profitability ac🅠ross a wider range, it dilutes the peak payoff.

Other challenges include 澳洲幸运5官方开奖结果体彩网:liquidity and 澳洲幸运5官方开奖结果体彩网:execution risk. The involvement of multiple options legs, particularly with non-standard strike ratios, can lead to less favorable market conditions for entry and exit. Wider bid-ask spreads and potential gaps in the market for these custom structures increase the risk of slippage. Last, rolling or adjusting your positions ca💦n become expensive, especially in markets with limited liquidity.

Modified Butterfly Spread and Theta/Time Decay

Time decay, or theta, is an important factor worth talking about with the modified butterfly spread. Time decay generally works to the trader's advantage because it erodes the value of the short options at the midd🎉le strike price faster than the long options. As time passes, the premium collected from the short options decreases which can lead to a profitable position if t🀅he underlying asset stays within the anticipated price range.

However, time decay can also pose a risk if the underlying asset moves significantly away from the middle st♈rike price. In this case, the long options that are further out-of-the-money may lose value too quickly while the short options at the middle strike might still retain significant value. This scenario could result in a net loss for the position as the gains from the short options might not be enough to cover the losses from the long options.

As expiration🙈 approaches, the impact of time decay becomes more pronounced. For a modified butterfly spread, this acceleration can either enhance profits or increase potential losses, depending on where the underlying asset is relative to the strike prices. If the asset’s price is near the middle strike, the rapid time decay of the short options can lead to significant gains. if the asset has moved far from the middle strike, the accelerated time decay would work against you.

The Bottom Line

Options offer traders a great deal of🔯 flexibility to craft a position with unique reward-to-risk characteristics. The modified butterfly spread fits into this realm. Alert traders who know what to look for and who are willing and able to act to adjust a trade or cut a loss if the need arises, may be able to find many high probability 𒅌modified butterfly possibilities.