BUTTERFLIES

Butterflies consists of a credit spread and debit spread either all calls or all puts. They seem to have a narrow profit zone and probability of profit but higher reward to risk ratio. They are among the highest rewarding neutral spreads if the underlying absolutely stays the same.

Here we have an example of a butterfly call spread. The spread would consist of the following OEX options on 5/2/01: (buy 1 may-01 675call @ 5.1) + (sell 2 may-01 655call @ 12.2) + (buy 1 may-01 635call @ 26.1)

From the PL graph above, we can see a generous reward to risk ratio of 1.48 but narrower profit zone producing a probability of profit at 49.4%. The lower probability of profit gives a lower expected return of $162.

From the historical price vs profit zone graph, we see that the OEX is likely to stay within the narrow profit zone with less than 20 days left.

Next, we form a butterfly put spread with the following options for OEX on 5/4/01: (buy 1 jun-01 675put @ 14.8) + (sell 2 may-01 640puts @ 21) + (buy 1 may-01 635call @ 33.2) The PL graph is shaped just like the butterfly call. There is a big max profit but narrow profit range. The risk reward ratio is a very good 2.13. This position can make as much as $1345 but can lose at most $630.

From the historical price vs profit zone graph, this position has room to stay within the profit zone with about 40 days left to expiration: