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From Theory To Practice

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How to Set Up a Free Butterfly

From Theory To Practice

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

Ah yes, the Free Butterfly – one of The Bat’s favorite little tricks. Typically, we pay a debit to put on a standard butterfly, but the Free Butterfly effectively entails ending up with a standard butterfly that you’ve been able to put on at zero cost. This is usually the result of either a ratio spread or a broken-wing butterfly (BWB) that you’ve transformed into a Free Butterfly.

A ratio spread is where you buy an ATM (or slightly OTM) spread, and you add an extra short unit on top of the short leg of that spread. Thus, it is essentially a butterfly that is missing its outermost wing (that last long option). Over the life of the trade, if you are able to buy that missing long option for the amount of the credit originally received on the ratio spread, then you will have created a Free Butterfly. A BWB contains an embedded short vertical; if you have a bearish bias, then you would use a call BWB and embed a short call spread, and if you have a bullish bias, then you would use a put BWB and embed a short put spread. Similar to the ratio spread, if you are able to buy back this embedded short vertical for an amount equal to the credit received when the BWB was established, then again you will have created a Free Butterfly. An example of each of these transformations is shown.

NOTE: I added a visual representation slide for the ratio turned free butterfly as the last slide, after the takeaways. I did not reference this in during the segment.

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