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The Butterfly and Synthetic Positions

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The best way to see how anything works is to break it down into smaller components. From there, it is much easier to understand how each contributes to the overall arrangement. In the case of option strategies, we want to break positions that are more complex down into synthetic positions to get a different perspective.

Just about everything can be broken down synthetically and the Butterfly is no exception. New traders are often overwhelmed by looking at the about the Butterfly with, “I’m long this option, I’m long two of these, I’m long this other one, and there are three different strikes and four options…” It is not overwhelming and definitely not that complicated if you step back and look at it synthetically. In the chart below, the left side shows the construction of a long May 55 Butterfly:

We can break this complicated looking structure down in just one simple step. Rather than view the long Butterfly as long one 50 call, short two 55 calls, and long one 60 call as we have done on the left, let’s pair them in a different way. Instead, pair the long 50 call with one of the short 55 calls. Then let’s pair the other short 55 call with the long 60 call as we’ve done on the right side of the diagram – and look what we have.

First, look at just the blue. We are long one May 50 call (+1), and short one May 55 call (-1). This is simply a long vertical call spread or, more specifically, a bull call spread. Now move a little further off to the right and look at the red numbers. We are short one May 55 call (-1) and long one May 60 call (+1). This is a short vertical call spread, or a bear call spread.

When you break down the long Butterfly on the left, you end up with two vertical call spreads that are converging against each other. In other words, the Butterfly is nothing more than a bull spread and a bear spread acting together. The May 50-55 call spread, represented by the blue, maximizes its profits if the stock rises to 55 or higher.

We know it maxes out at 55. Anything above 55 is just extra security. That is our ability to sleep at night. Meanwhile, our short May 55- 60 call spread to the right represented in red maximizes its profits if the stock falls to 55 or below. So if the bull spread maximizes at 55 or higher and the bear spread maximizes at 55 or lower then a stock price of 55 will maximize both spreads.

Both of these converging spreads want the stock to go to the Butterfly’s middle strike, and that is exactly what you want to happen when you are in a long Butterfly. You want that stock price to finish directly at the middle strike - in this case, the 55 strike. That is your goal, because if it does, your vertical call spread maxes out on a positive side and your short vertical call spread also maxes out on the negative side. Fifty-five is where you want this position to close.

We stated earlier that most butterflies are initially set up with the short “center” strikes at-the-money. Once again, the reason is because it is a premium collection strategy and we want to be short at-the-money options since that is where the biggest extrinsic value is. Too many people forget that the Butterfly is a premium collection strategy. We are not looking for big stock movement. We are looking for stagnation. We are going to use our two short at-the-money options that are rich with decay. They have big extrinsic value, and we want to collect that extrinsic value. We capitalize on this by shoring two of them.
Now remember, the difference with the Butterfly is that it is a premium collection strategy that has a hedge. The hedge derives from the outer strikes, or the 50 call and the 60 call in this example. We know from a reward standpoint that vertical spreads provide a limited reward for both the buyer and the seller. In addition, from a risk standpoint, the buyer and the seller have limited risk.

Let’s look first at our left side – the blue side – the long 50-55 call spread. If you own the 50 call and sold the 55 call, what is the worst that can happen? Think back to your basic rights and obligations with options. You have the right to buy stock for 50 and the obligation to sell it for 55, which means the most the spread will ever be worth is the difference in strikes, or five dollars in this example, if the stock rises to 55 or higher. Therefore, if the stock is at 55, that is great; we maxed out the spread.

If the stock trades down to 50, we are going to lose everything. But – and it is a big but – we are not going to lose any more than what we spent. That is the risk scenario of a vertical call spread: you can only lose what you spent to enter the vertical spread so it is a limited risk strategy.
Therefore, for our Butterfly, if the stock started trading down, our risk is limited to 50. If the stock continues to fall below 50, it does not matter since our risk is fixed at 50.

Look at the other half of the Butterfly - the short 55-60 call spread. If we are short the 55 call and long the 60 call then we have the right to buy stock for 60 and the obligation to sell it for 55, which results in a five-dollar loss if the stock is 60 or higher at expiration. We obviously want the stock to close at 55 or below.

As a seller, we have maxed out our spread and our profit in the spread. Remember, if the stock were to run up above 60, our loss is limited in that spread because the vertical spread has a limited loss scenario for both the buyer and the seller.

The Butterfly therefore consists of two conflicting spreads. One spread wants the stock to move higher while the other wants it to move lower. Both spreads ideally want the stock to move to, or better yet, if we put it on properly, stay at 55. Moreover, if by chance the stock moves in either direction against this, we have a limited loss scenario. There is your premium collection and your hedge.

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