A butterfly is a neutral, income-oriented options strategy. It is a limited-risk and limited-profit trade, but on a typical butterfly trade, the profit potential is higher than the potential loss.
Butterfly spreads involve three different option strike prices, all within the same expiration date, and can be created using either calls or puts.
A typical butterfly would be constructed as follows:
Buy one in-the-money call
Sell two at-the-money calls
Buy one out-of-the-money call
Today, we will look at an example with Goldman Sachs:
Buy one July 15-expiry 280 call at 18.75
Sell two July 15 300 calls at 7.75
Buy one July 15 320 call at 2.25
Total Cost Of Trade $550
The total cost of this trade is $550, and that is the maximum loss potential on the trade.
The maximum gain is $1,450, which is calculated by taking the difference in strike prices less the premium paid ($2,000 less $550).
The break-even prices are 285.50 and 314.50 (lower strike plus the premium and upper strike minus the premium).
A butterfly options trade, has a tent-like shape with the potential for very large profits around the short strike. It's important to keep in mind that it's unlikely you would ever achieve the maximum profit.
Aim For 20% Return On Goldman Sachs Trade
A good aim for a butterfly trade is to make a 20% return on capital at risk. In this case, that would be around $110.
According to the IBD Stock Checkup, Goldman Sachs stock is ranked No. 8 in its group and has a Composite Rating of 49, an EPS Rating of 64 and a Relative Strength Rating of 37.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
