A stock option butterfly can be formed in one of 3 ways.

• Type 1: Long 1 Jan (S-D) Call, Short 2 Jan S Calls, Long 1 Jan (S+D) Call.
• Type 2: Long 1 Jan (S-D) Put, Short 2 Jan S Puts, Long 1 Jan (S+D) Put.
• Type 3: Long 1 Jan (S-D) Put, Short 1 Jan S Put, Short 1 Jan S Call, Long 1 Jan (S+D) Call.

S is a strike price, and D is a delta strike price, so S+D is a valid new strike and S-D is also a valid strike. D can span more than 1 strike price. For example, Stock options have strikes that vary by 5's,(85, 90, 95, 100, 105 etc.). S could be set to any strike. For example, it could be 95. D could be 5, 10, 15, 20, 25, 30 etc. If D=15, S+D is 110, a valid strike, and S-D is 80, another valid strike.

Butterflies always use the same option month. In the example above we used January options. The three butterflies have the same risk curve and are known as Long Butterflies. Types 1 and 2 are known as call and put butterflies respectively, and type 3 butterflies are called "Iron Butterflies".

Let's do a few risk charts using the "Risk Graph" web page and show charts for each type of butterfly using REAL quotes. We invite you to reconstruct these charts yourself using the Risk Graph analyzer in Create An Option Trade.

• Go to the Welcome Page.
• Enter the date 06-01-99 in the text box.
• Enter DJX (Dow Jones Index) in the text box.

The web site range of dates moves forward in time as a 2 year window from the latest available date. If 06-01-99 is not an option, select your own more recent date in the past to use for this example.

New users will not have this date showing! You will only have the last 5 days, which is default. We can get more dates to appear using My Personal Data. Click the My Personal Data button on the Welcome page.

• Click My Personal Data.
• On this screen:
• Change "Access from: " to the earliest available date.
• Scroll all the way to the bottom and click the SAVE button.

Midway in the Risk Graph analyzer screen is "Add a New Option or Underlying". Enter the following:

• Long 1 Aug99 DJX 105 Call @ Market
• Short 2 Aug99 DJX 110 Call @ Market
• Long 1 Aug99 DJX 115 Call @ Market
• Click "Update Option Trade".

Click the Save Option Trade button at the bottom of the page.

After saving the trade, you are in the Backtest Engine.

• Change the end date to 8-20-99 at the bottom for multi-day analysis, and the start date to 6-01-99.
• Click on the multi-day analysis button.

• Click the all dates button.
• You should consider changing your access dates in My Personal Data.

The trade does not show much of a profit until the last few days before expiration. This is common with butterflys.

Hit the Browser Back key to return to the Backtest Engine page.

We will do it differently to enter the put butterfly.

• Click the "See Risk Graph" button on the Backtest Engine page.
• Go to the call Butterfly trades near the center of the page on the Risk Graph
• Change all the calls to puts.
• Change "Purchase Price" to "Market Price".
• Click on the Update Option Trade button.

Return to the Welcome Page.

• Put in the date 6-01-99 and DJX as the stock.
• Click Create An Option Trade.
• Enter the following four trades on the Risk Graph Analyzer screen:
  • Long 1 Aug99 DJX 105 Put @ Market
  • Short 1 Aug99 DJX 110 Put @ Market
  • Short 1 Aug99 DJX 110 Call @ Market
  • Long 1 Aug99 DJX 115 Call @ Market

You can also analyze Long Condors by just typing in the trades. The web site does not do Iron Butterflies or Condor searches. Search can look for potentially profitable long and short butterflies. The new Platinum v2.0 does search for Iron Butterflies and Condors.

All three of these butterflies have similar risk/reward numbers. You can see on the plots that time decay is the greatest in the final weeks of the trade. There are several approaches to trading butterflys successfully.

One method is to trade only high reward/(-risk) flys that have 3 weeks or less remaining. The objective is to try to ride them out for a few weeks and capture the time decay.