This segment reveals the results of a study to determine the optimum distance between strikes when placing a butterfly spread. The results and analysis should help your decision making process.
A call butterfly spread is constructed by purchasing a vertical call spread and selling a higher vertical call spread with the same short strike. A put butterfly is constructed similarly but with the direction lower. Butterflies are generally made up of all calls or all puts. When IV rank (IVR) is high butterfly spreads are cheaper.
We can increase the trade’s probability of profit by increasing the width between our long and short strikes. The trade-off is that higher probability butterflies are more expensive. The question then is what is the optimal width of a butterfly spread? At what point does the increased cost of the trade outweigh the potential increase in profitability?
A study was conducted from 2009 to present buying a butterfly in the SPY (S&P 500 ETF) every five days using the options closest to 45 days to expiration (DTE). The width between the long and short calls (as a percentage of the underlying) were varied from 2.5% wide, 5% wide, 7.5% wide and 10% wide.
A table was displayed comparing the different widths. The table showed the results of the percentage of profitable trades, average trade P/L, average winner, average loser and max profit/loss for each width.
A second part of the study measured the effect of IV Rank on butterflies. The trades were broken down into butterflies that were initiated when IV Rank was above 50% those that were below 50% IV Rank. A table was displayed comparing the different widths of 2.5%, 5%, 7.5% and 10% for each wing. The table showed the results of the percentage of profitable trades and average trade P/L for IV Rank above and below 50%.
The probability of having a profitable trade at expiration didn’t necessarily increase as the IV Rank increased but the average profit did. Additionally, we tend to see larger profits when using wider strikes and when IV Rank is higher.
Watch this segment of "Market Measures" with Tom Sosnoff and Tony Battista for the takeaways to learn which width and IV Rank is best to increase our profitability and probability in trading butterflies.
The traders in this segment are using features of dough, our trading platform.
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