Over the last few weeks I have started to trade butterflies more frequently. I have been trying out a new strategy to fit my risk profile while increasing my profits exponentially with little added risk. The one thing that is needed to trade butterflies is patience. As I mature as an option trader I have learned that the one thing that has made me successful is patience, and without it, many of my trades would have never reached their potential, or I would have exited with losses to soon and not give myself a chance to recover.

To make butterflies successful, there is one thing I knew I had to do. First, I had to do ATM trades, with around a 4-8% span between the two long strikes. The way to determine how far apart the strikes should be you have to factor in the implied volatility (what the option market is pricing in) and also what you expect. For example, let's say you wanted to trade AAPL ahead of a product launch, you would want to give yourself a wide range due to the increased possibility of a big move. However, if you wanted to trade the SPY for upside for the shortened July 4th week, you are probably best with a 1-1.5% range as the implied volatility is probably low and you have more certainty as to where SPY may end the week. It is critical (at least for my strategy) to trade ATM trades. What does ATM look like? Which leg determines whether the strike is ATM? To determine whether the fly (short for butterfly) is ATM, look at your first long leg. For example, if AAPL is at 124 and you buy the 124-128-132 call fly, it is ATM, as the 124 strike is where AAPL currently is.

There are a few reasons why I always trade ATM. The first is because; I do not want to NEED a move to breakeven. How is that possible? If you were to buy an ATM fly, in most Implied volatility scenarios you will not experience time decay to a day before expiration (for short term flies/weeklies) and a few days before (for flies that you bought with more than 1 week to expiration). What this means that with your first long strike (take the 124 strike for AAPL, so if AAPL went to 124.50) you would be profitable, regardless of whether it was 1 day before expiration or 3-4 etc., days before expiration. This is a huge advantage, as you do not have to worry about losing 50% of your money in a matter of days solely due to time decay. The second reason is because of the hedge that I put on for every trade. The hedge is critical because it lets me risk a lot more on my original fly because I know that if I am wrong my hedge will cover some of the losses. The last reason I trade ATM is because I still have the opportunity to have exponential profits even though I only need a few percentage point move. Let us walk through an example with P/L figures to illustrate the positives of incorporating hedge into your butterfly strategies. I will use AAPL illustrate my point.

Example Scenario:

Current Price of AAPL: 124

Main trade: AAPL 124-128-132 weekly call fly @ $.85 (This would be the cost on the Friday before expiration. I usually buy flies exactly one week before expiration so I can profit from the decay of the short strikes)

Hedge Trade: 123/125 put spread for $1. I am buying the ATM put spread so if AAPL ends at 124 on Thursday I have not lost anything. The last thing you want is your hedge and long trade to both be losses.

This is an estimated Profit Model. Notice the difference between Thursday and Friday profitability. I will explain when to hold a fly to expiration and when not to. Also notice how AAPL being at 124 is the same as 132 (125 is the same as 131, etc.) The reason is because both are $1 ITM; it does not matter if it is above or below the short strike.

Profit Model on Thursday:

124/132: Value of Fly: $.50-$.60 (30% loss)

125/131: Value of Fly: $1.1 (30% gain)

126/130: Value of Fly: $2 (130% gain)

127/129: Value of Fly: $2.4 (180% gain)

128: Value of Fly: $2.7 (220% gain).

Hedge Value on Thursday:

124-125: 30% Loss

125-126: 50-75% Loss

126+: 90-100% Loss

Total P/L on Thursday:

124-125/131-132: Total P/L is around a 30-40% loss (assume 10% loss on Fly and 30% gain on hedge)

125-127/129-131: Total P/L is around 0%-80% (assume 130% gain on the Fly and 50-75% loss on Hedge).

128: 130% gain (220% gain on the Fly and 90% loss on the Hedge)

Now Lets Take a Look at the Loss Model (scenario if AAPL falls) for Thursday:

(I am estimating the profit/loss based on a P/L model I use on my platform)

120-122: Put Spread: 80-90% profit. Call Fly: 90% loss. (Total is around a 10% loss)

123-124: Put Spread: 20-50% profit. Call fly: 50% loss. (Total is around a 0-30% loss)

Now Let's Take a Look at the Risk/Reward Model:

Our worst case scenario is if AAPL ends between 123-125 as here we are looking at 30% losses (Worst Case) as our Risk. 128 is our best price, giving us a total profit of 130%. In turn our risk/reward is 4.3:1. (123 is our breakeven on Friday on the downside and 126 is the upside. That is if you hold till 4pm Friday).

Now this trade offers a 4.3:1 Risk reward even before expiration. If you hold the trade through Friday and AAPL ends between 127-129 you are looking at an extra $.5-$1 of profitability which is an extra 60-100%. So, if you hold the trade till Friday you are looking at a risk/reward of 6.3:1 – 7.6:1. One thing to note; a butterfly will never reach FULL value. This AAPL trade will never reach $4, because even if AAPL is at 128 at 3:55pm on Friday expiration, the short 128 will still be worth $.05-$.07. Therefore, never hold a trade expecting it to reach the absolute maximum gain.

You can tell by the Risk/Reward why I think butterflies are a great strategy. If you wanted to offer yourself a 4-7:1 Risk/Reward for a regular AAPL call (let's say the ATM call) you would need AAPL to move $8-$14 a week (ATM call usually goes for $1.5).

I only think it is appropriate for someone to hold a fly into expiration day, that is, sell on Friday rather than Wednesday/Thursday, if you are almost positive that regardless of how much the stock moves that Friday you will be profitable. For example, if AAPL is at 128 (using the example above) come Thursday, it is safe to assume AAPL won't gap up or down $3 or more to make this trade a loss. However, if AAPL were at 130.50, only $1.5 ITM, unless you had a really good feeling the market is going to fall the next day, I do not think it would be smart to hold into Friday.

Many option traders strive to make 500-1000% gains but most likely lose every time.  The reason is that to make those kinds of gains you have to do way out of the money and need a big move quickly. (Now there are times where I just trade outright calls/puts because I expect a big move quickly, but nowadays I rarely do that because I find that spreads/flies are much smarter.) However the traders that try to make that much, risk 100% each time. One wrong move and the options are worthless. So looking at the risk model for OTM options, I think it is safe to assume that the risk/reward is 5-10:1 with the odds of profitability very low. Now go to my AAPL trade, my risk/reward is 4-7:1. However my odds of success are much greater. What is more likely, betting that a stock like NFLX moves $20-$40 in a week or betting AAPL rallies/sells-off $2-$4 in a week? I would say AAPL.

Every trader must find his or her niche. I have found that I am most successful when I trade 1-2 things a week and risk more on those, than buy 10 different trades. Some traders are the opposite. This butterfly strategy is probably meant for those who are like me, that is, only trade 1-2 things a week. 

Disadvantages of Trading Butterflies:

1. Butterflies are not very profitable until a day before expiration (and not extremely profitable until Expiration day). These means that not only do you have to predict the way the stock moves but you also have to predict where it ends the week. It is hard enough to say which way a stock goes but to say it is going to end the week in a particular price range is even harder.
2. Your trade can be going very well 2-3 days before expiration and then all of a sudden the stock moves too much (whichever way) and you lose.
3. Unlike regular spreads and calls/puts, butterflies can be losses if your stock moves TOO much, even the right way. If you think AAPL rallies $4 this week and do a fly accordingly, but AAPL moves $10 up, you lose 100%. This is a reason I recommend hedges when you are near the danger zones (that being when you are at the lower or upper end of the wingspan).
4. They are very stressful. Speaking from a psychological point of view it is very hard to root for the stock to rally one sec and sell-off the next. For the AAPL example, you want the stock to rally but not too quickly. Every penny matters and it can make trading more stressful. I remember one time when I bought a FB call fly for earnings (in July 2012), the stock soared way past my upper range of the fly. Even though I called the move, I lost on the trade. Because of that experience I only trade flies for earnings on low IV stocks.
5. Spreads can be very wide on many stocks .I would only recommend trading flies on names like SPY, AAPL, NFLX, TWTR, FB (and names with penny intervals in their option pricing). Names like GPRO or FEYE make trading flies very hard as you have INSANE bid add spreads. Don’t forget that when trading flies you have to account for the bid/ask spread of 3 different strikes, not just one (for outright calls/puts) or 2 strikes for verticals/calendars.
6. Fees are much more. Because you have 3 different strikes, so if you do these, I suggest using a broker that charges you no more than $50 a contract. I usually have to pay $50-$100 per trade. 

To summarize, butterflies can be very profitable if you have two things: patience and a hedge. I believe that with both you can be very successful trading flies. The benefits of trading butterflies are that there is very little time decay, you have a phenomenal risk/reward, and you do not need a big move to be profitable. Butterflies offer the exponential profits that every options trader strives for, but with greater probability of success. Lastly, when trading flies do not be greedy. If come the Wednesday or Thursday before expiration you think the stock will move outside of your profitable zone, close out the trade, there is always the next trade.