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Spread Your Wings with a Butterfly Call Spread

July 26, 2011 by John Payne| Tips & Strategies

A butterfly option spread is a multiple option position that involves the simultaneous purchase of calls or puts with the sale of calls or puts.  The way the spread will be established will depend on how bullish or bearish one is on a market.  The same rule applies with other option strategies; there is no such thing as a free lunch.  The more one pays for these spreads, the higher the profit potential will be.  Butterfly spreads are easier defined as a bull call spread combined with a bear call spread.  With the understanding that most option strategies like this are difficult to understand, let’s look at an example.

How to Construct the Spread

Many traders have been very bullish on the corn markets over the last few years.  Due to very loose monetary policies and tight fundamentals, the corn market has been quick to rally on any bullish news.  Lately, the heat wave that has come across much of the Corn Belt has created another potential rally from which to be profited.  Kurt, a corn trader, believes corn will rally, but also believes there is significant demand destruction above 8.00.  He also believes the market will have a hard time getting much over that hurdle.  He is an option trader who enjoys the comfort of maximum risk/maximum reward trades.  Further, Kurt enjoys sleeping at night knowing that he cannot lose more than he pays for a trade.  In the case of a market that has a potential to rally he looks to his primary strategy, the bull call spread.

Normally, a bull call spread would be his preferred way of capturing gains from a bullish market, but, because he feels that 8.00 corn will not be demanded, he wants to sell the market over that price.  Thus, he is going to combine two option spreads to form a butterfly call spread.  He will buy one close to the money call, sell two further out of the money calls, and buy one even further out of the money call.  Here is how his option spread will look with September corn trading at 6.90:

  • Buy 1 725 September Corn Call for 25 cents – Pay $1250
  • Sell 2 8.00 corn calls for 8 1/4 cents each (combined 16.5 cents) and collect 825
  • Buy 1 8.75 Sep corn call for 3 cents – Pay $150 dollars

Kurt will end up paying $575 for this spread before fees, which will be his maximum risk on the trade.  His maximum profit will be achieved if Corn settles at 8.00 on August 26.  If that happens, he will make a profit of $3175 (spread value at expiration of $3750 and cost paid for the spread $575).

8.00 will be Kurt’s maximum profit point.  If this were just a 725-800 call spread, Kurt would be happy to see the market rally as far as it can.  His only desire would be that Sep Corn expires over his short 8.00 call so his max profit will be achieved.  Keep in mind he would have paid $838 dollars for that spread.  Because he sold an additional 800-875 call spread he will be losing money for every cent the market expires over 8.00.  If the corn market rallies and expires over 8.75, Kurt will actually be taking a loss on the trade of the premium paid.  His profit/loss is broken down on the theoretical option chart below.

Please click to view the Options risk disclosure below.
Theoretical Corn Option Chart

Corn Chart

For those new to these kinds of charts, we want to focus on the blue straight line.  This is the profit line of the option spread at the corresponding price of corn on Aug 26, the day of expiration.  The other lines show profit at different points before the option expires.  As you can see, by selling the 800-875 call spread along with the purchase of the 725-800 call spread he is trading off the profits over 8.00 for the ability to spend/risk less initially on the trade.  The chart shows that a Sep Corn expiration above 8.75 will yield the same loss as an expiration below 7.25.  So we are essentially using options to pin down an exact point where we believe the expiration will occur.  With these types of strategies it is important to realize we are playing with the expiration price and not where corn prices will be next week or any time prior to expiration.  We will always have the ability to exit the trade whenever we choose, but we will only achieve the maximum profit upon expiration.

The flexibility of options to create spreads like these are one of the best reasons to trade them.  Kurt can use a combination of spreads to design a strategy for exactly what he believes will happen.  Whether you are using spreads as protection or as speculative tools, it is important to know the different ways their use can be a productive tool.

For more information or explanation on the strategy discussed here, or any other futures/options information, please contact your Daniels Trading broker.

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Filed Under: Tips & Strategies

About John Payne

John Payne is a Senior Futures & Options Broker and Market Strategist with Daniels Trading. He is the publisher of the grain focused newsletter called This Week in Grain, along with being a co-editor of Andy Daniels’s newsletter, Grain Analyst. He has been working as a series 3 registered broker since 2008.

John graduated from the University of Iowa with a degree in economics. After school, John embarked on a 4 year career with the United States Navy. It was during two tours in Iraq and the Persian Gulf where John realized how important commodities are to the survival of society as we know it. It was this understanding that brought about John’s curiosity in commodities. Upon his honorable discharge in 2007, John’s intense interest in the world of commodities inspired him to move to Chicago and pursue his passion in a career in the futures arena.

After a three year position with a managed futures firm specialized in livestock trading, he was given the opportunity to join the team at Daniels Trading. Being in the business and seeing how other IB’s operated, it was the integrity and straightforward approach of the Daniels management team and brokers that attracted him to make the move. Since joining Daniels, John has broadened his fundamental and technical analysis of the markets even further. John has been writing his newsletter This Week in Grain under the Daniels banner since 2011.

Working in high pressure industries like the military and capital markets, John has learned the value of preparation in times of stress. He believes that instilling within his clients the value of a good plan and a cool head for dealing with the day to day swings of commodity markets. He treats every client as a teammate, understanding that his job is to help clients achieve their goals, whatever they may be.

John is a proud supporter of the Iraq and Afghanistan Veterans of America, the Veterans of Foreign Wars and the National Corn Growers Association. When he is not working, he enjoys athletics of all kinds and spending time with his wife and their two kids.

John’s commentary is featured in the following publications:

* All Ag Radio – Sirius Channel 80
* AM 880 KRVN – Lexington, Nebraska
* RFD TV
* Wall Street Journal
* Barron’s
* China News Daily (English version)

Risk Disclosure

WHEN INVESTING IN THE PURCHASING OF OPTIONS, YOU MAY LOSE ALL OF THE MONEY YOU INVESTED.

WHEN SELLING OPTIONS, YOU MAY LOSE MORE THAN THE FUNDS YOU INVESTED.

YOU SHOULD BE AWARE THAT IN THE EVENT YOU LIQUIDATED THE LONG SIDE OF A BULL CALL SPREAD AND STILL MAINTAINED THE SHORT OPTION POSITION, THEN YOUR RISK WOULD BE UNLIMITED.

This material is conveyed as a solicitation for entering into a derivatives transaction.

This material has been prepared by a Daniels Trading broker who provides research market commentary and trade recommendations as part of his or her solicitation for accounts and solicitation for trades; however, Daniels Trading does not maintain a research department as defined in CFTC Rule 1.71. Daniels Trading, its principals, brokers and employees may trade in derivatives for their own accounts or for the accounts of others. Due to various factors (such as risk tolerance, margin requirements, trading objectives, short term vs. long term strategies, technical vs. fundamental market analysis, and other factors) such trading may result in the initiation or liquidation of positions that are different from or contrary to the opinions and recommendations contained therein.

Past performance is not necessarily indicative of future performance. The risk of loss in trading futures contracts or commodity options can be substantial, and therefore investors should understand the risks involved in taking leveraged positions and must assume responsibility for the risks associated with such investments and for their results.

Trade recommendations and profit/loss calculations may not include commissions and fees. Please consult your broker for details based on your trading arrangement and commission setup.

You should carefully consider whether such trading is suitable for you in light of your circumstances and financial resources. You should read the "risk disclosure" webpage accessed at www.DanielsTrading.com at the bottom of the homepage. Daniels Trading is not affiliated with nor does it endorse any third-party trading system, newsletter or other similar service. Daniels Trading does not guarantee or verify any performance claims made by such systems or service.

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Risk Disclosure

This material is conveyed as a solicitation for entering into a derivatives transaction.

This material has been prepared by a Daniels Trading broker who provides research market commentary and trade recommendations as part of his or her solicitation for accounts and solicitation for trades; however, Daniels Trading does not maintain a research department as defined in CFTC Rule 1.71. Daniels Trading, its principals, brokers and employees may trade in derivatives for their own accounts or for the accounts of others. Due to various factors (such as risk tolerance, margin requirements, trading objectives, short term vs. long term strategies, technical vs. fundamental market analysis, and other factors) such trading may result in the initiation or liquidation of positions that are different from or contrary to the opinions and recommendations contained therein.

Past performance is not necessarily indicative of future performance. The risk of loss in trading futures contracts or commodity options can be substantial, and therefore investors should understand the risks involved in taking leveraged positions and must assume responsibility for the risks associated with such investments and for their results.

Trade recommendations and profit/loss calculations may not include commissions and fees. Please consult your broker for details based on your trading arrangement and commission setup.

You should carefully consider whether such trading is suitable for you in light of your circumstances and financial resources. You should read the "risk disclosure" webpage accessed at www.DanielsTrading.com at the bottom of the homepage. Daniels Trading is not affiliated with nor does it endorse any third-party trading system, newsletter or other similar service. Daniels Trading does not guarantee or verify any performance claims made by such systems or service.

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