may sometimes provide an opportunity to traders that they were not looking for initially. It’s a good example of the importance of . Movement in the underlying, the passage of time and/or in may mean a trader can turn a ratio spread into a “free” . What does it mean that there is a “free” Butterfly and how and why would we choose to employ this strategy?
You may have heardand say, “We bought an OTM wing so now we have a free Butterfly.” It may sound confusing but it’s really quite simple. It starts with a 1 x 2 Credit Ratio Spread. An example of a Ratio Spread in XYZ stock trading at $100 was displayed. The example showed buying 1 of the $95 puts and selling 2 of the $90 puts for a net credit of 0.10. If XYZ stock is above $95 at the Ratio Spread will have a $10 profit. Should the opportunity arise to buy the $85 put for 0.10 or less then the Ratio Spread would turn into a Butterfly Spread and the cost would be zero (or better) and hence the Butterfly would be “free”. Another way to think of the this Ratio Spread is as a Debit Put combined with a . Buying the other Put makes this a Debit Vertical spread combined with a Credit Vertical Spread. There is no risk and should the underlying be around $90 at expiration we have a much larger winner with no concern about losing money to the downside.
A graph of the SPY (S&P 500 ETF) was shown. The time period covered was from Mid January of 2016 to Mid February. It was noted that a 1x2 Put Ratio Spread of long one $183 put and short two $180 puts for a net credit of $2.26 had been established on January 20, 2016 when the SPY was trading at $185.65. By Jan 22, 2016 SPY had moved up to $190.52 The Feb 177 Put was trading for $1.06. Buying the 177 put means owning the 177/180/183 Put Butterfly for a $1.20 Credit. There is now no longer any upside or downside risk and maximum profit will occur if the SPY would be at $183 at expiration. Additionally, thechanges to reflect the lack of risk which frees up capital to be used on other trades and allowing us to increase our .
For more on Ratio Spreads see:
Closing The Gap from March 31st, 2015:
Best Practices from August 10th, 2015:
Closing The Gap from June 1st, 2016:
Watch this segment of Options Jive with Tom Sosnoff and Tony Battista for the important takeaways and a better understanding of trading Credit Ratio Spreads and how they can be turned into a free Butterfly Spread.