Butterfly options are options involved in an investment strategy that is structured to provide a limited amount of returns even if the degree of risk associated with the underlying assets of the options should change over the future. The process involves utilizing a series of long and short calls in order to create a pattern that helps to insulate the investor from incurring any losses, even if the implied risk associated with the options is different from the future risk that eventually emerges. As with many options strategies, structuring butterfly options requires careful planning and selection and an attention to detail in order to succeed.
There are actually two different types of butterfly options. One is known as the long butterfly. With this arrangement, all the options involved will have the same expiration date. The series of calls will involve a long call that has a strike price that is slightly lower than the benchmark, followed by two short calls at the benchmark. As the final phase of the process, a long call is initiated at a price slightly higher than the strike price. The combination helps to offset the chance for loss overall, allowing the investor to effectively minimize the chances for loss while helping to improve the chances for earning at least a modest return.
Short butterfly options also use either a series of calls or sometimes a combination of puts and calls in order to produce the desired result. The difference is that with a short butterfly approach, the combination of short and long calls is reversed, meaning that where long calls are used in the long butterfly, short calls are substituted. At the same time, the short calls in the long butterfly are replaced with long calls in the short butterfly approach. This arrangement, assuming the selection of options is ideal, is more likely to produce revenue if the future volatility of the options is greater than the implied volatility.
The timing in butterfly options is very important to the success of the strategy. Along with choosing the right options, it is key that the changes in volatility are observed throughout the process, and that each of the calls involved are initiated at just the right time. While somewhat complicated, this approach is capable of producing returns that make the time and effort worth it to many investors. Typically, newer investors only attempt this approach by working closely with a seasoned broker who is capable of identifying the right combination of options and could also advise as to the timing of each call.
