Directional Butterflies
Trading a butterfly can be an excellent way to establish a low-cost,
relatively low-risk directional trade when a trader has a specific price target
in mind. For example, a trader, Ross, has been studying Walgreen Co.
(WAG) and believes it will rise from its current level of $33.50 to $36 per
share over the next month. Ross buys a butterfly consisting of all OTM
January calls with 31 days until expiration.
He executes the following legs:
As a directional trade alternative, Ross could have bought just the January
35 call for 1.15. As a cheaper alternative, he could have also bought the 35–
36 bull call spread for 0.35. In fact, Ross actually does buy the 35–36
spread, but he also sells the January 36–37 call spread at 0.25 to reduce the
cost of the bull call spread, investing only a dime. The benefit of lower cost,
however, comes with trade-offs. Exhibit 10.5 compares the bull call spread
with a bullish butterfly.
EXHIBIT 10.5 Bull call spread vs. bull butterfly (Walgreen Co. at $33.50).