A butterfly trade is a neutral, income-oriented strategy. It is a limited-risk and limited-profit trade. But on a typical butterfly, the profit potential is higher than the potential loss. Here's an example involving Amazon stock.
Butterfly spreads involve three different option strike prices, all within the same expiration date. They can be created using either calls or puts.
A typical butterfly would be constructed as follows:
- Buy 1 in-the-money call
- Sell 2 at-the-money calls
- Buy 1 out-of-the-money call
Amazon Stock Option Trade Setup
Today, we will look at an example on Amazon.com. We will give the trade a bearish bias to start.
- Buy 1 April 19, 160 put @ 1.50
- Sell 2 April 19, 170 puts @ 3.95
- Buy 1 April 19, 180 put @ 8.90
The total cost of this trade is $250 and that is the maximum loss potential on the trade.
The maximum gain is $750. That's calculated by taking the difference in strike prices, multiplied by 100, and subtracting the premium paid ($1,000 minus $250).
The break-even prices are 162.50 and (lower strike plus the premium and upper strike minus the premium).
Amazon Option Trade Profit Range
A butterfly trade risk graph has a tent-like shape with the potential for very large profits around the short strike. It's important to keep in mind that it's unlikely you would ever achieve the maximum profit.
A good aim for a butterfly trade is to make a 20% return on capital at risk. In this case that would be around $50 per contract.
According to the IBD Stock Checkup, Amazon stock is ranked No. 1 in its industry group. It has a Composite Rating of 95, an EPS Rating of 82 and a Relative Strength Rating of 92.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on X/Twitter at @OptiontradinIQ
