Butterfly spreads are a popular strategy among option traders and aim to take advanced of sideways prices in a stock.
The trade aims to make a profit from stable stock prices and / or a drop in implied volatility.
You can learn more about butterflies in my 12,000 word guide.
One stock that caught my eye yesterday was Salesforce (CRM) with a huge 26% move after earnings. What I’m looking for now with this stock is some sideways movement and consolidation of those gains.
Let’s take a look at how we could set up an butterfly trade on Salesforce.
Butterfly spreads involve 3 different option strike prices, all within the same expiration date, and can be created using either calls or puts.
A typical butterfly would be constructed as follows:
Buy 1 in-the-money call
Sell 2 at-the-money calls
Buy 1 out-of-the-money call
Let’s take a look at how that might look on CRM stock.
Buy 1 Sept 18th 250 call @ 26.85
Sell 2 Sept 18th 270 calls @ 14.45
Buy 1 Sept 18th 290 call @ 7.30
The total cost of this trade is $525 and that is the maximum loss potential on the trade.
The maximum potential gain is $1,475 which is calculated by taking the difference in strike prices less the premium paid ($2,000 less $525).
The breakeven prices are 255.25 and 284.75 (270 plus and minus 14.75)
A butterfly options trade, has a tent-like shape with the potential for very large profits around the short strike. It’s important to keep in mind that it’s unlikely you would ever achieve the maximum profit.
A good aim for a butterfly trade is to make a 20% return on capital at risk. In this case that would be around $105 per contract.
Butterfly spreads can be a bit confusing for beginners, so it’s best to paper trade this way and see how it performs.
For a stop loss I would close the trade if CRM broke through either 255 or 295.
The author may have a position in mentioned securities at the time of publication. Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.