Profit Potential on Butterfly Spreads and Ratio Spreads
To achieve "max profit" you have to "pin the short strike". Confused? That's a good reason to read on.
- Max profits on butterfly or ratio spreads require meeting two simultaneous criteria.
- First, you need to pin the short strike on either strategy—missing on either side will take away from max profit.
- Second, you need the pin of the short strike to occur close to expiration, so that most of the extrinsic value has disappeared from the options.
While butterfly spreads and ratio spread might seem to be vastly different strategies on the surface because one is defined-risk and the other is undefined-risk. But they are quite similar when it comes to one key component: the maximum profit potential of each strategy.
To achieve anywhere near the maximum profit for a Butterfly or Ratio, you need to nail two things simultaneously - you need to pin the short strike, and you need to be close to expiration.
Pinning the short strike
So, if the short strike on your strategy is 45, you need the stock at, or close to, 45 for a chance to earn maximum profitability. If the short strike on your strategy is 100, you need the stock at, or very close to, 100, and so on.
If the stock is too far away from your short strike, then you will either not have maximized the long vertical spread component of the strategy, or the short premium component of the strategy (by way of a short vertical with a butterfly or simple short option with a ratio) will be too far in-the-money. Both scenarios work directly against any efforts to hit max profit on these strategies, so you need to pin the short strike as closely as possible.
Close to expiration
Furthermore, if max profit is the objective, it’s not enough to just pin the short strike; you must pin the short strike very close to expiration.
It’s likely that pinning the short strike early in the expiration cycle won’t be enough to earn you significant profits, and if it happens too early, it could actually lead to showing losses on either strategy.
This is simply because both a butterfly spread and ratio spread are short premium strategies that benefit most from the short options losing their extrinsic value. If the stock approaches the strike of those short options too quickly, then its extrinsic value will rise —the opposite of what you want out of the position. Therefore, anything near max profit on a Butterfly or Ratio is only realistic in the final days of the expiration cycle.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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