How to use a butterfly spread when trading options

One of the things investors like about options trading is the flexibility it gives them. With options, traders can employ different strategies and tactics.

One such strategy is the butterfly spread. BayCrest Managing Director, Equity Derivatives David Boole says the butterfly strategy is "used more when there's a lot more volatility in the market." He adds that traders like them because "for a small amount of premium, you get exposure to a wide range."

Watch the video above to hear Boole explain butterfly trades that were made based on the iShares 20+ Year Treasury Bond ETF (TLT) and Nvidia (NVDA).

For more expert insight and the latest market action, click here to watch this full episode of Market Domination.

This post was written by Stephanie Mikulich.

Video transcript

With investors keeping a close eye on the tech trade and rates.

We're taking a look at how investors can get a foot in the door through options trading.

But which strategy should investors know and use will be breaking down one in particular with bare managing director David Bull in this segment sponsored by Tasty Trade.

So David, you are looking at butterfly spread options, that strategy.

So first of all, let's just talk in general terms about what a butterfly is because there are lots of these different methods within options.

What is a butterfly?

That's right.

It's a combination of calls or puts one side of the market and and I've seen them used on both sides lately and it's especially used more when there's a lot more volatility in the market and options cost cost more than they have in previous regime.

We've all felt that the market is moving up and down over 1% lately.

And so traders are getting more creative with the types of options strategies that they put on.

So a butterfly put butterfly strategy is where you buy, uh buy the put that you want the exposure to and then you sell 22 units of the next lower strike put and then you cap your downside essentially.

So if we wanna go through an example, um Well, wait, what hold, hold that thought because so effectively, you're saying the stock is gonna fall, but it's only gonna fall by so much, you're sort of capping how much downside there is in that given in this example is that the right way to describe it exactly.

For a small amount of premium, you get exposure to a wide range and that's why traders really like them and your risk is limited to the premium that you spend.

So if the stocks falls by a ton or rises by a ton, you're just risking that small amount of premium and then you get exposure to that wide range.

If you get incredibly lucky and the lottery hits and you get, and it settles right at that middle strike, then often times you can get nearly a 10 X payout.

Most traders go into these trades not expecting to get that 10 X payout, but are happy to get 2345 X.

In the meantime, you have a structure that carries well.

It doesn't decay as much as just buying a put out right?

Or buying a call out, right?

And um you get exposure to a wide range to express a view.

And so you're talk, we're, we're talking to clients David and when you talk to them give us some ideas.

What are you telling them?

Well, right now, uh everyone's watching, you know, the different economic events, the fed next week trying to get a handle of this new volatility regime in my world.

Everyone's talking about Vick at 20 which if you zoom into the last six months, that's in the 95th percentile volatility is high and traders are feeling that uh but if you zoom out, that's still quite normal, the market is moving about 1% options are fairly priced.

It's just, it's just more expensive than it has been.

So I'm seeing traders stay nimble in today with um with short dated calls and puts, but then if you're trying to express a view over the next 1 to 1.5 weeks that captures the fed, um Many are employing some of these more creative option strategies that, that reduce the cost of the premium outlay.

All right.

So let's get to the TLT put, fly, fly short for butterfly in this particular case.

So how does it work?

So, in this specific example, um so this is a trade that actually at the tape.

Um Yesterday, a trader bought the TLT September 99 strike puts uh one time sold, two of the 97 strike puts and then bought back the 95 strike put, the 95 strike put is essentially just to cap the downside of TLT, which is the long bond ETF falls an incredible amount.

You're still capping your downside, you've bought two puts and you've sold two puts.

And in this example, paid about 20 cents for this and uh the max profits in the middle at two at 97.

And if it, if it happens to settle there, which would be incredibly lucky, uh the trader would make uh nearly 10 times the money, right.

So basically, for people who aren't familiar with that sort of payout diagram, we decided that's what we're gonna call it.

The payout diagram.

You know, if it settles around 97 it shows that the peak profit there is just under two bucks, correct.

Right.

Which as you said, if you're paying 20 cents, yes, I can do math.

It's sorry, I'm telling myself um that you would get that almost $2.

That's right.

The beauty is the wide range where you're just paying 20 cents for this, for this wide range from nearly 90 you make money 9520 to 9880.

And so rates have rallied a lot in September 10 years, uh has moved about 30 basis points and it's overbought on many metrics.

If you're looking at the, the bond, ETF STLT and IEF so many traders are thinking, wow, this looks like a very quick move.

I would like to fade this move, but I'm not sure when the timing is gonna happen if it's gonna happen on CP I this morning or maybe it's gonna happen on uh the fed next Wednesday.

But I just wanna play for this, the TLT to kind of mosey back into this range one more.

David.

I won't, won't surprise you one name we talk a lot about on the show.

NVIDIA.

What's a smart option strategy there?

So um NVIDIA uh had a huge intraday range today from 108 all the way up into 116.

And um I've uh trade the coal butterfly.

Actually, the same strategy works on NVIDIA.

NVIDIA is a uh the options are priced high as well.

Um About 50% implied volatility which which implies about a 4% move per day in NVIDIA stock.

So again, traders are thinking, I think NVIDIA, I'm a B on NVIDIA.

I think it might go higher, but I think there may be a ceiling, it had trouble getting through the 130 level after earnings.

So a trade that could make sense is buying the NVIDIA September 1 21 25 130 call butterfly spending about 50 or 60 cents on that one.

And where you could still make this, you know, if you get lucky in the middle, you can make nearly 89, 10 times your money.

But instead it's giving you a range of also, it's giving you a range from 120 to 130 to play NVIDIA moving higher.

And that's also where we've seen the flow switch a little bit where the narrative is clients just buy calls in NVIDIA on the rally.

I'm actually seeing more clients sell some puts and sell calls at play.

NVIDIA.

Staying in a range.

David.

Great to have you and great ideas.

Appreciate it.

Thanks.