Strategy: Butterfly, Reverse

a.k.a. Short Butterfly

The Outlook: Bullish or bearish, but not neutral. The stock must fall or rise for the strategy to gain.

The Trade: buy Put and Call ATM, sell Call one strike OTM, sell Put one strike OTM. See end of page for credit variations.

Gains when: stock rises or falls past the breakeven points.

Maximum Gain: Limited to difference in strike prices — initial debit (for this variation).

Loses when: stock does not rise or fall enough.

Maximum Loss : limited to the initial debit (for this variation).

Breakeven Calculation: Lower breakeven = middle strike — initial debit. Upper breakeven = middle strike + initial debit. (For this variation.)

Advantages compared to stock: limited risk, less capital needed, greater leverage, can gain from a move in either direction.

Disadvantages compared to stock: Position will lose if stock does not move, or does not move enough.

Volatility: after entry, increasing implied volatility is positive.

Time: after entry, the passage of time is negative if the stock does not move, but positive if the stock rises or falls past the breakeven points.

Margin Requirement: None for this variation, after initial debit is paid in full.

Variations: See the bottom of this page for credit-entry variations using all calls or all puts.

• The Reverse Butterfly can be used if you expect a sharp stock price movement one way or the other. For instance, you may expect such a movement at earnings time on a stock that historically has large movements in reaction to the earnings report, but you feel earnings could be either disappointing or great.

• The strategy has limited profit potential to the upside and the downside, so you don’t want to be too bullish or bearish. Use the Backspread with Calls if you are more bullish than bearish, the Backspread with Puts if you are more bearish than bullish, or the Straddle Purchase if you are expecting a large move in either direction.

• A somewhat similar strategy is the Straddle Purchase. Compared to a Straddle Purchase, the Reverse Butterfly:

• Is entered for less of a debit (or for a credit on the variations shown below).
• Has a lower maximum loss.
• Cannot gain as much if the stock rises or falls dramatically.

Exits

• Since this strategy needs stock price movement to be profitable, if the stock does not move as expected, it is best to exit the trade with less than the maximum loss. Using the example graph, if the stock has not moved within two weeks (and you were expecting the movement by then), you can exit with a loss of about $75. If you just sit and wait, you may have to take a loss of over four times that much — $311.

• If the stock rises or falls past one of the breakeven points, time will work in your favor at that stock price, so you may want to hold on for maximum gains. However, there is always the chance of a reversal that might take the stock price back to the worst possible range.

• Using the example graph, if you determine to take your losses at $75, you might also take any gains of around $150 whenever you have them, and eliminate the risk of a possible stock price move against you .

Adjustments

• The example position can be thought of as a combination of a Bull Call and a Bear Put. If you feel the stock is going to trend, and the stock starts moving higher, you can close out the Bear Put and try to stick with the Bull Call. Or if the stock starts moving lower, you can close out the Bull Call and stick with the Bear Put.

• A completely opposite strategy if you think the stock is going to bounce around, would be to take the gains on whichever side is winning, wait for a reversal, and take gains on the other side as well.

• Everything needs to work out just right for either of the above two techniques to succeed. In the long run, you may be better off following a take small losses and larger gains philosophy rather than trying to predict stock movement too precisely.

Just like the Butterfly, the Reverse Butterfly can be constructed with all calls or all puts, for a nearly identical position. The main difference is both of these variations are entered for a credit and will require margin.