Dear Profit Takeover reader,
I wanted to do a breakdown today to help explain when to choose spreads vs butterflies vs straight calls and puts…
When a trader buys multiple calls and/or puts at different strike prices simultaneously, that is called a spread trade.
And there’s even a way to combine spreads for an even more focused trade called a butterfly…
First, let’s do a quick review.
There are two different types of options:
A call is the option to buy a stock (100 shares) at a certain price (strike price) on or before a specific date (expiration date).
And a put is the option to sell a stock (100 shares) at a certain price (strike price) on or before a specific date (expiration date).
A trader will buy calls when they think the stock is moving higher, and they will buy puts when they think the stock is moving lower.
Traders can buy multiple calls and/or puts to protect their trades, minimize risk, and create a hedge, or when they have a specific speculation of how the market will move.
Here are three spread strategies that traders use that combine calls and puts and why traders like them:
Bull Call Spread
If a trader believes a stock is heading higher (bullish), they can buy calls at one specific strike and sell the same number of calls at a higher strike price simultaneously on the same stock with the same expiration date.
Utilizing this strategy, called a bull call spread, a trader will limit their upside on the trade but also limit their risk, and it will reduce the option’s overall cost compared with buying a naked call.
Bear Put Spread
When a trader thinks a stock is heading lower (bearish), they could buy puts at one strike and sell the same number of puts at a lower strike price simultaneously on the same stock with the same expiration date.
This strategy is called a bear put spread, and allows the trader to reduce the option’s overall cost but limits both their upside on the trade and their risk on the downside compared with naked puts.
Now these spreads could end up costing the trader or paying the trader to open, which would put it into one of two categories: debit spread or credit spread.
If the purchased option costs more than the sold option, that is considered a debit to the account and is called a debit spread.
The opposite is true for credit spreads. If the value of the options sold is greater than the value of the purchased options, there is a net credit to the account. Traders sometimes say they were paid to open the trade in this case.
I use butterflies on the SPX and XSP same-day expiration plays.
A butterfly is a combination of a bull spread and a bear spread where the sold strikes overlap in the middle –
For this strategy, a trader will buy one lower strike, sell two middle strikes, and buy one higher strike.
So for a call butterfly for example, you’d buy one call at a low strike, sell two calls at the middle strike, and buy one call at a higher strike, all on the same stock and same expiration date.
When I execute butterflies in SPX and XSP, I determine the middle strike based on where I think the stock will land at expiration and the low and high strikes are typically the same amount away from the middle strike for a balanced butterfly.
It’s essentially setting up a bullseye at the center where I think SPX will land that day.
Butterflies are perfect when traders want to minimize risk but are willing to cap the potential profit.
If you’d like to learn how to execute butterfly trades in real-time every weekday, sign up right here for Expiration Trader.
Luckily, you can still get in at the Founding Member discounted price… so join before this opportunity is over.
Until next time,
November 26 2022