Constructing Butterflies Around Expected Close Price

Setup Definition and Market Context

Once a potential pin risk candidate has been identified, the next step is to construct the butterfly spread around the expected closing price. The construction of the butterfly is a important step that will determine the profitability of the trade. This article will provide a detailed guide on how to construct a butterfly spread to maximize the potential for profit while minimizing risk.

Entry Rules

• Choosing the Right Options: You can use either calls or puts to construct the butterfly. The choice between calls and puts depends on the trader's preference and the specific market conditions. In general, if the stock is trading slightly below the pin strike, it may be better to use calls. If it's trading slightly above, puts may be a better choice.
• Selecting the Strikes: The short strike of the butterfly should be the identified pin strike. The wings should be equidistant from the short strike. The width of the wings will determine the risk and reward of the trade. A wider spread will have a higher potential profit but also a higher cost. A narrower spread will have a lower potential profit but also a lower cost.
• Timing the Entry: The butterfly should be entered in the last two hours of the trading day on expiration Friday. This is when the pinning effect is strongest and the time decay of the options is most rapid.

Exit Rules

• Winning Scenario: Hold the position until expiration to maximize profit.
• Losing Scenario: Close the position if the stock moves outside the wings of the butterfly. A 50% stop-loss on the premium paid is recommended.

Profit Target Placement

The profit target is the maximum profit potential of the butterfly spread, which is the width of the spread minus the debit paid.

Stop Loss Placement

A 50% stop-loss based on the premium paid is a simple and effective way to manage risk.

Risk Control

• Max Risk Per Trade: 1% of trading capital.
• Daily Loss Limits: 2% of trading capital.
• Position Sizing Rules: Based on the 1% max risk rule.

Money Management

• Fixed Fractional: The recommended approach.

Edge Definition

The edge comes from the high probability of a pin occurring when the right conditions are met, combined with the high risk-reward ratio of the butterfly spread. The win rate is around 40%, with an R:R of 5:1 or higher.

Common Mistakes and How to Avoid Them

• Using a spread that is too wide or too narrow: The width of the spread should be carefully chosen based on the stock's volatility and the trader's risk tolerance.
• Entering the trade too early or too late: The timing of the entry is important for this strategy.
• Not understanding the risk/reward profile of the trade: It's important to know the maximum profit and loss of the trade before entering.

Real-World Example

It's expiration Friday, and MSFT is trading around $300. The $300 strike has a high open interest. A trader decides to enter a long call butterfly with strikes at $297.50, $300, and $302.50, paying a debit of $0.40. The maximum profit is $2.10. MSFT closes at $300.10. The butterfly expires with a profit of $2.00.