The Out-of-the-Money (OTM) Butterfly Spread is a distinctive strategy in the world of option trading with an exceptional reward-to-risk potential, if properly implemented. Options are traded for various reasons – to speculate on price movements, to hedge existing positions, or to employ advanced strategies for generating regular additional income.
A Butterfly Spread, specific to option trading, generally involves buying a call option at a strike price, while concurrently selling two call options at a higher strike price, and buying another call option at an even higher price. Similarly, you can use put options by buying one put option at a strike price, selling two at a lower price, and buying another at an even lower price. This strategy generates a 'profit range', and typically acts as a neutral strategy.
In a neutral Butterfly Spread, as shown in Figure 1 with options on First Solar (FSLR), the risk and profit potential are limited. For instance, the trading risk is bound to the net amount paid for the trade - in this scenario, $580, with a maximum potential gain of $1,420 if FSLR closes at $130 during option expiry.
An OTM Butterfly Spread is a 'directional' trade, relying on the underlying stock moving in the expected direction for the trade to profit. This is built similarly to the neutral spread pattern, with the crucial distinction being the selling of an out-of-the-money option instead of an at-the-money one.
The risk/reward profile for an OTM call butterfly, as shown in Figure 2, indicates a maximum risk of $493 and a maximum profit potential of $2,007 if the underlying FSLR stock moves above the breakeven price of $140 per share before expiry.
The OTM Butterfly is advantageous when anticipating a stock's modest rise without a definite forecast of how much the stock will surge. If significant shifts are anticipated, a call option with unlimited profit potential is recommended.
The OTM Butterfly strategy offers a low-risk trade with an appealing reward-to-risk ratio, and a high likelihood of profit when using calls, especially in scenarios of low implied option volatility. The main drawback is the necessity of accurately predicting the market direction. There are numerous Butterfly Spread variations such as long and short call and put spreads, combining both bull and bear spreads.
Overall, the OTM Butterfly Spread can provide options traders three chief advantages - an entry cost significantly lower than buying 100 shares of the underlying stock; a highly favorable reward-to-risk ratio; and a high probability of profit with a wide profit range between upper and lower breakeven prices. Few trading strategies offer all these distinct advantages. However, investment decisions should always be driven by the investor's risk tolerance and investment objectives.