Long butterfly
© 2006, Reprinted with permission of Active Trader magazine (www.activetradermag.com)
Market bias: Non-directional.
Components: Options with three different strike prices at equidistant intervals: Buy one each of the highest and lowest strike price options and sell two of the middle strike price options.
Rationale: To benefit from the short options’ decreasing volatility and accelerating time decay. You can use this strategy if you think the underlying market will be at or close to the middle strike price at expiration.
Maximum profit: The premium collected from the two short options plus any remaining value in the long options (occurs when the underlying market settles at the strike price of the middle options at options expiration).
Maximum loss: The initial price paid for the spread.
You can structure a butterfly entirely of puts or calls, or a mixture of both. You choose three strike prices at equidistant intervals and buy one each of the highest and lowest strike price options and sell two of the middle strike price options. The middle, two-option part of the spread is the “body” of the butterfly, and the upper and lower options are the “wings.”
While the standard long butterfly is most profitable when the market closes at the short option’s strikes, Taleb likes to combine this position with long extremely OTM options that could produce large gains if the market spikes significantly up or down.