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Market Measures

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Butterflies: Varying Widths

Market Measures

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

We generally are premium sellers but we realized there is interest in trading strategies besides Delta Neutral ones. A Vertical Spread is a directional strategy that we have examined before, such as in the Market Measures segment on January 15, 2014, Directional Vertical Spreads. By adding a short Vertical Spread with the same short striike as a long Vertical Spread we create a Butterfly Spread. A P/L graph of a Butterfly Spread was displayed. The graph showed that the “Home Run” strike at which you are most profitable at expiration is the short strike. Since the placement of the wings determines the trade’s Probability Of Profit (POP) we wanted to determine the optimal width for a Butterfly. What is that optimal width?

Our study was conducted in the SPY (S&P 500 ETF) using data from 2009 to the present. We bought a Butterfly every 5 days using the option expiration cycle closest to 45 days to expiration (DTE). We varied the widths of each wing as a percentage of the underlying and held the trade to expiration. The percentages used were 2.5%, 5%, 7.5% and 10%.

A table of the results included the percentage profitable for each width, average trade P/L, average winner, average loser and max profit/loss. The table showed that as the wings widen the percentage profitability, P/L and average winner rises as well. We then divided the results into instances when Implied Volatility Rank (IVR) was above 50% and below 50%. The results in instances when IVR was above 50 produced dramatically better results, especially in the 7.5% and 10% widths. A segment next week will explore buying power efficiency of using different widths - i.e. “optimal widths”.

Tom noted, “My takeaway is when we are doing Butterflies going forward now, the smart way to do this is to get wider, reduce contract size and find Implied Volatility over 50 because the P/L numbers actually triple!”

For more on Butterfly Spreads see:

Watch this segment of Market Measures with Tom Sosnoff and Tony Battista for the valuable takeaways and the detailed results of our study on varying widths of Butterflies and how widening widths and waiting for high IVR dramatically increases our P/L and win rates.

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