A regular butterfly option strategy is a neutral or a non-directional strategy where we can profit if the stock moves in a particular range. However, a modified butterfly is a directional strategy, where we make profit if stock moves in our favor but won’t face losses even if the stock remains sideways. We incur losses only when the stock moves against our favorable direction.
It can be created with only Call options a.k.a Long Butterfly or only Put options a.k.a Short Butterfly. But for this particular module or blog, we will be focusing only on modified butterfly option strategy.
They are of two types:
Bullish/Call Butterfly
Bearish/Put Butterfly
The main objective of this strategy:
- To make profits from directional movement of the stock
- To protect losses due to theta decay if stock moves sideways
Let’s start with a bullish/Call modified butterfly which consists of 3 legs. They are as follows:
Buy +1 ATM/Near OTM Call
Sell -2 OTM Call
Buy +1 Next OTM Call (not equal strikes)
Take a look at the above example, where Buy ATM Call & Selling OTM Calls are of equidistant strikes. However the 3rd leg of buying Far OTM call has been modified with taking a long position 50 points higher rather than 100 points, which makes it a modified butterfly.
Hence one side is completely protected & maximum profit can be realized if it trades in a range bound near the -2 OTM strike that is sold. Loss will only occur below our breakeven point.
Now, let’s discuss a bearish/Put modified butterfly which also consists of 3 legs. They are as follows:
Buy +1 ATM/Near OTMPut
Sell -2 OTM Put
Buy +1 Next OTM Put (not equal strikes)
Take a look at the above example, as the pay-off graph seems exactly opposite to the modified call butterfly. Only difference is the strategy is built with Puts. The view here is bearish. Maximum profit can be realized when price moves in a favorable direction but consolidates near the -2 OTM Strikes which are sold. However, in case it moves further in a favorable direction strategy remains profitable & loss will occur only when it goes above the breakeven point.
Thus, modified butterflies are useful when you wish to create an open ended directional strategy unlike regular butterflies where if the stock moves beyond the range, the strategy incurs loss.
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