In trading, as in life, timing is everything. Often, the difference between winning and losing is not what you do but when you do it.
For traders who want to implement butterfly spread strategies, the timing quandary is no different. Read on to learn more about these types of trades and when executing one is a good idea.
Timing the Butterfly Spread
A butterfly spread is an advanced trading strategy that involves simultaneously buying and selling multiple futures or options contracts. The primary goal of this strategy is to optimize risk and reward while capitalizing on a market bias. However, although the concept is the same in both the futures and options versions, there are nuances that you need to understand.
Futures Market Applications
In the futures markets, the butterfly spread consists of buying and selling like contracts with unique expiration dates. By implementing this strategy, a trader is positioned to profit from rising or falling asset prices while being insulated from unexpected periodic volatility.
To illustrate how this strategy works in futures markets, let’s take a look at a real-world example. In the following scenario, assume that Corey is a Nebraska corn farmer who is expecting a bumper crop in the coming year. This should bring an abundance of supply come harvest time and place pressure on CME corn futures (ZC) pricing. After planting is complete (early June), Corey executes the following trade:
- Buys one lot of July ZC at 647’0
- Sells two lots of September ZC at 576’0
- Buys one lot of December ZC at 543’0
Structurally, Corey’s spread has two legs: July/September and September/December. By executing the strategy shortly after planting, Corey is insulated from bullish July volatility while still holding a bearish view toward harvest pricing.
So why place this trade? In short, to address potential market uncertainty. In commodities such as corn, supply and demand levels vary throughout the year, as do prices. For Corey, a midsummer spike in corn prices would hurt a naked fall short hedge; by taking the aforementioned actions, he can mostly mitigate this risk.
Options Market Applications
An options butterfly spread is a “neutral market” strategy that involves the buying and selling of four call and put contracts with identical expiration dates. The trade is executed by purchasing or writing at-the-money (ATM) and out-of-the-money (OTM) contracts at three different strike prices. This type of spread is used to secure bullish or bearish market exposure with a finite profit/loss matrix.
To say the least, the mechanics of multi-legged options spreads are complex. To learn more about how this one functions, check out our dedicated blog post on the topic, “What Is a Butterfly Spread Option Strategy?”
So when should one put on an option butterfly spread? Here are few instances in which you may want to consider executing the strategy:
Moderate Bullish/Bearish Bias
In the event that implied volatility is expected to be modest, this type of spread can be exceedingly profitable. If price doesn’t move much from a base level, both the bought and sold contracts may expire in the money (ITM). However, when dealing with trending markets, buying calls or puts outright offers a potentially greater upside.
Capital Constraints
The vast majority of retail traders operate with limited capital. In this case, butterfly spreads can be used to secure market exposure while limiting liabilities. Because of the simultaneous buying and selling of contracts, the money needed to initiate the trade is vastly reduced, as is the assumed risk.
Is Spread Trading Right for You?
Without a doubt, futures and options spreads are among the most confusing subjects in all of finance. However, despite their intricacies, they can be useful in achieving almost any financial goal.
If you’re new to the world of spread trading, don’t be intimidated―enlist the services of a Daniels Trading market pro instead! Sign up for your free one-on-one futures and options consultation today.
