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Ready to Master the Butterfly Spread Strategy?
Imagine this: A major economic report is coming out today, and you anticipate a big move in the market based on actual numbers in the economic report. However, you are not sure in which direction the market will move. Is there a way to trade this scenario?
Now, picture a different scenario where an earning release is scheduled. And you expect the earnings numbers to be in line with market expectations. And you are expecting no market moves. How can you trade this scenario?
Well, the answer to both questions is through an options strategy such as butterfly, straddle, strangle or iron condor.
In today’s Quantra classroom, you'll delve into the Butterfly Spread, exploring its types and use cases while gaining insights into creating entry and exit rules for short butterfly strategy. This strategy can be applied to all "European Type" options such as S&P 500 index options and we have a dedicated section in the “Systematic Options Trading” course which explains sourcing US options data.
It is important to note that backtesting results do not guarantee future performance. The presented strategy results are intended solely for educational purposes and should not be interpreted as investment advice. A comprehensive evaluation of the strategy across multiple parameters is necessary to assess its effectiveness.
All the concepts covered in this post are taken from the Quantra course on Systematic Options Trading. You can preview the concepts taught in this course by clicking on the free preview button.
Note: The links in this tutorial will be accessible only after logging into quantra.quantinsti.com
What is a Butterfly Spread Strategy?
The Butterfly Spread is an options trading strategy that involves combining buying and selling call & put options to create a position.
There are two variations of the Butterfly Spread: the long butterfly and the short butterfly.
Long Butterfly Spread: This strategy is structured to profit from minimal price movement in the underlying asset. It entails buying one lower strike option, selling two middle strike options, and buying one higher strike option.
The resulting position forms a profit zone around the middle strike price, making it suitable for scenarios where the trader expects the market to remain relatively rangebound or stable.
Short Butterfly Spread: In contrast, the short butterfly spread is employed to profit from significant price movement in the underlying asset. It involves selling one lower strike option, buying two middle strike options, and selling one higher strike option.
This strategy is advantageous when anticipating substantial price swings away from the middle strike price.
Both variations of the Butterfly Spread are recognised for their limited risk and limited reward profile, making them strategic choices in specific market conditions.
The long butterfly excels in low-volatility environments, while the short butterfly is suitable for scenarios with an expectation of significant price fluctuations.
Why Choose a Long Butterfly Spread Over a Short Straddle Strategy?
Both strategies are deployed when the market is expected to remain range-bound.
Risk Management
Traders prefer the long butterfly as it has capped risk. In contrast, a short straddle has unlimited risk if the stock makes a significant move in either direction. And more suitable for intraday trading with strict stop loss.
Time Decay
Another reason is long butterflies can benefit from reduced time decay losses compared to short straddles. If the stock remains close to the middle strike, the time decay on the two long options may offset the time decay on the two short options.
Lower Capital Requirement
A long butterfly typically requires less initial capital compared to a short straddle because it involves buying and selling options at different strike prices.
Similar reasons are applicable when deciding short butterfly over the long straddle option.
How to Create a Short Butterfly Trading Strategy?
The short butterfly strategy is employed in anticipation of significant market movement and increased volatility, particularly when the implied volatility (IV) is high.
Source: CBOE
The above shows an option chain for SP500. The current price is $4538. Here are the steps to create a short butterfly trading strategy.
Step 1: Initiate the strategy by buying one call option and one put option at the at-the-money (ATM) strike of, for instance, 'SPXW 4540.000'.
Step 2: Next, sell one out-of-the-money (OTM) call option with a higher strike, such as 'SPXW 4550.000'.
Step 3: Finally, sell one out-of-the-money (OTM) put option with a lower strike, like 'SPXW 4530.000'.
What are the Entry and Exit Rules?
Typical entry rules for a short butterfly strategy involve anticipating significant market movement.
Entering a short butterfly strategy depends on two conditions:
- Historical data indicating a weak or no trend. You can use technical indicators such as ADX to determine the trend.
- Market participants forecast significant volatility (market movement). This can be calculated with the help of the implied volatility metric such as the 'IV percentile'.
Exiting a short butterfly strategy involves closing the positions in four contracts of the strategy at the expiry.
How to backtest this strategy?
You can backtest the above strategy in Python. You can calculate the technical indicators and stats to generate entry and exit signals. Finally, you can backtest the strategy on historical options data and check its performance. We had backtested a similar strategy in the systematic options trading course and below were the results.
The Python code for the above strategy can be found in this unit of the Systematic Options Trading course. The backtesting code is structured in a way that allows for easy modification to accommodate various option strategies such as iron condor, straddle and strangle. It is important to note that backtesting results do not guarantee future performance. The presented strategy results are intended solely for educational purposes and should not be interpreted as investment advice. A comprehensive evaluation of the strategy across multiple parameters is necessary to assess its effectiveness.
You need to take a Free Preview of the course by clicking on the green-coloured Free Preview button on the right corner of the screen next to the FAQs tab and go to Section 17 and Unit 10 of the course.
What to do next?
- Go to this course
- Click on
- Run the codes in the course
- Drop us your comments and queries on the community
Machine Learning for Options Trading
If you are looking to learn how to create an ML model to assist you in selecting the right option strategy to deploy, you can check out our course, Machine Learning for Options Trading.
IMPORTANT DISCLAIMER: This post is for educational purposes only and is not a solicitation or recommendation to buy or sell any securities. Investing in financial markets involves risks and you should seek the advice of a licensed financial advisor before making any investment decisions. Your investment decisions are solely your responsibility. The information provided is based on publicly available data and our own analysis, and we do not guarantee its accuracy or completeness. By no means is this communication sent as the licensed equity analysts or financial advisors and it should not be construed as professional advice or a recommendation to buy or sell any securities or any other kind of asset.
