This is the second part in the discussion on butterfly option spreads.  The first part is available at the link below:


Part 1 discussed the potential jackpot returns, and also defined the butterfly formulas, including maximum risk and maximum reward.  Now let’s look at an example, as shown from the excel screen shot below.  You can download the excel spreadsheet (geldpress-option-calc) here.  The spreadsheet includes a custom visual basic black-scholes option calculaltor function, and thus will only work on Microsoft Excel (Open Office does not come with Visual Basic extensions).

The butterfly spread in the example above started with the following assumptions:

  • Initiated on the Russell 2000 (RUT) on 8/28/08 at a price of 731.6
  • Buy to open (1) September 720 strike call
  • Sell to open (2) September 730 strike calls
  • Buy to open (1) September 740 strike call
  • Assume 22.5% implied volatility on the entry of all 3 spreads, along with 3% risk free rate of return
  • Use the custom excel function geldpress_call and ignore dividends

Fast forward in time to 9/10/08, with the following assumptions:

  • Implied volatility decreases to 20% (decreasing volatility is GOOD for butterfly spreads)
  • Russell 2000 gains in value to 750 (outside the expiration day breakeven points!)

The result may be a little surprising.  The original calculations for expiration day break even points were between 720.98 (lower strike plus initial debit) and 739.02 (upper strike minus initial debit).  But the pre-expiration day break even points can be wider then the expiration day break even points.  The example above considers the possibility of the Russell 2000 hitting the 750 mark, 10 points above the upper break even point.  But because there was still time left in the option spread, it was still possible to have an unrealized profit in the spread - $20.48 per spread in our example.

The next logical question is to ask when is the best time to close a butterfly spread.  And the answer to that is not so straight forward.  If you believe the Russell 2000 will remain outside the break even range, then you may consider closing early with a small profit if you can.  If you think it will revert to the middle strike, or at least within the expiration day break even range, then you can take your chances for a higher potential profit.

The other scenario that was not considered is the scenario where your position races against you and creates an unrealized loss.  This could occur if the Russell races to well above the 750 mark, with much less time remaining in the butterfly spread.  Even in this scenario, adjustments can be made, but they are unfortunately beyond the scope of this article.  For more information on adjusting option positions and turning losing trades into winning trades, I recommend the following book:

The Option Trader Handbook: Strategies and Trade Adjustments (Wiley Trading)
The Option Trader Handbook: Strategies and Trade Adjustments (Wiley Trading) by George Jabbour