The butterfly option strategy is an advanced trading technique that provides an explosive bullish or bearish market exposure with a high-risk reward. In this blog post, we will explore the butterfly option strategy, an example of how it works, and key factors to consider when executing this strategy.
Overview of the Butterfly Option Strategy
The butterfly option strategy is constructed as follows:
- Buy 1 call option at a certain strike price
- Sell 2 call options at a strike price above the first one
- Buy 1 call option at an even higher strike price
This combination of options creates a risk-reward profile that can deliver substantial returns if the underlying asset settles at a specific price.
Overview of the Butterfly Option Strategy
Let's consider a practical example using Bitcoin (BTC) options:
- Buy 1x 31k call option
- Sell 2x 32k call options
- Buy 1x 33k call option
Assume that the 31k/32k/33k butterfly for 26 May currently costs $75 per BTC, with a BTC spot reference of 29,088.
The maximum payout occurs if BTC settles at 32k on 26 May. In this case, the payout equals $1,000. Since the cost of the structure is $75, the risk-reward ratio can be calculated as follows:
Risk-reward ratio = Maximum payout / Cost of the structure = 1000 / 75 = 13.33
In this example, the potential reward is 13.33 times the amount paid to trade this structure.
Key Considerations for Butterfly Option Strategies
When evaluating a butterfly option strategy, it's important to consider the following factors:
- Strike prices: Choose the strike prices carefully, as they will determine the potential payout and risk-reward ratio.
- Expiration date: The expiration date of the options will affect the cost of the structure and the time frame for potential gains.
As with any option strategy, it's crucial to evaluate the strike prices and expiration date carefully to maximize the potential returns and minimize the risks. By understanding the components and considerations of the butterfly option strategy, traders can take advantage of this high-risk reward approach to capitalize on specific market conditions.