In my previous post, I discussed what is a calendar spread in futures trading. It is one of the best-kept secrets in the retail trading world as most traders are unaware of it.
In this post, let's learn about another form of spread trading - Butterfly Spread.
Before you proceed...
Be sure to learn about what a calendar spread is by checking out my prior posts below:
What is a Butterfly Spread?
In futures trading, a butterfly spread is a trading approach that involves the simultaneous buying and selling of multiple calendar spread contracts.
For instance, (i) the buying of 1 lot Natural Gas (NG) January/February (F:G) calendar spread, and (ii) the selling of 1 lot NG February/March (G:H) calendar spread makes up for an NG F:G:H butterfly spread.
To simplify this further:
Buying 1 lot of NG F:G calendar spread = +1x NG F contract and -1x NG G contract
Selling 1 lot of NG G:H calendar spread = -1x NG G contract and +1x NG H contract
As a result, the butterfly spread formed from the above is:
+1x NG F contract -2x NG G contracts -1x NG H contract
Visual comparison: Outright trading vs Calendar Spread vs Butterfly Spread
When it comes to trading, being bullish or bearish in outright trading, calendar spread, and butterfly spread mean very different thing:
Being bullish (buy) means... | Being bearish (sell) means... | |
|---|---|---|
Outright trading | Outright price rises | Outright price drops |
Calendar spread | Calendar spread widens | Calendar spread narrows |
Butterfly spread (ideal condition) | Nearer calendar spread widens (eg. Jan/Feb), while further calendar spread narrows (eg. Feb/Mar) | Nearer calendar spread narrows (eg. Jan/Feb), while further calendar spread widens (eg. Feb/Mar) |
Being bullish, a visual comparison:
Being bearish, a visual comparison:
Ways Traders Profit from Butterfly Spread
Since there are 2 calendar spreads in play (1x buy AND 1x sell) when it comes to trading a butterfly spread, traders are essentially betting on the total outcome of a simultaneous buying AND selling of calendar spread trades.
Let's look at how a butterfly spread trade profit in a Bullish scenario:
Ideal scenario: Gains from the buying of nearer calendar spread (eg. Jan:Feb spread) AND Gains from the selling of further calendar spread (eg. Feb:Mar spread):
Gains from buying a nearer calendar spread (spread widens) | Gain from selling a further calendar spread (spread narrows) | Total gains |
|---|---|---|
+5 pts | +5 pts | +10 pts |
The gain from the buying of a nearer calendar spread is LARGER than the loss from the selling of a further calendar spread:
Gains from buying a nearer calendar spread (spread widens) | Loss from selling a further calendar spread (spread widens) | Total gains |
|---|---|---|
+5 pts | -3 pts | +2 pts |
The loss from the buying of a nearer calendar spread is SMALLER than the gains from the selling of a further calendar spread
Loss from buying a nearer calendar spread (spread narrows) | Gains from selling a further calendar spread (spread narrows) | Total gains |
|---|---|---|
-2 pts | +5 pts | +3 pts |
Let's look at how a butterfly spread trade profit in a Bearish scenario:
Ideal scenario: Gains from the selling of nearer calendar spread AND Gains from the buying of further calendar spread:
Gain from selling a nearer calendar spread (spread narrows) | Gain from buying a further calendar spread (spread widens) | Total gains |
|---|---|---|
+10 pts | +7 pts | +17 pts |
The gain from the selling of a nearer calendar spread is LARGER than the loss from the buying of a further calendar spread:
Gain from selling a nearer calendar spread (spread narrows) | Loss from buying a further calendar spread (spread narrows) | Total gains |
|---|---|---|
+10 pts | -5 pts | +5 pts |
The loss from the selling of a nearer calendar spread is SMALLER than the gain from the buying of a further calendar spread:
Loss from selling a nearer calendar spread (spread widens) | Gain from buying a further calendar spread (spread widens) | Total gains |
|---|---|---|
-3 pts | +10 pts | +7 pts |
Butterfly Spread Application
As a butterfly spread consists of the buying and selling of futures contracts of different expiration dates at the same time, a trader will be able to make profit, or hedge his positions regardless of rising or falling outright price movement.
For instance, a corn trader is expecting a larger-than-average harvest in the coming year, which may result in an oversupply during harvest period that'll place bearish pressure on corn futures (ZC) pricing. After planting season ends in early June, he executes the following trade:
Buys 1 lot of ZC July contract at 418'0
Sells 2 lots of ZC September contract at 350'0
Buys 1 lot of ZC December contract at 320'0
In other words, there are 2 calendar spreads in play, namely: Buy ZC July/September and Sell ZC September/December calendar spreads. Doing so will protect the corn trader from bullish July volatility while maintaining his bearish conviction toward the harvest price of corn in the later months.
Benefits and Downsides of Trading Butterfly Spread
Benefits:
Trading butterfly spread is not influenced by the volatility of outright price
Trading butterfly spread generally requires less margin than outright futures contracts
Downsides:
Since trading butterfly spread involves 4 futures outright positions at one time, it will involve higher commissions and fees.
While most platforms offer calendar spread combinations, many do not offer readily tradable butterfly spread combinations. Traders that want to trade butterfly spread may need to manually execute 2 calendar spread trades instead, which may make the execution less smooth in actual trading.
Verdict: Use the knowledge of butterfly spread to form edge in trading
While concepts like calendar and butterfly spread may seem intimidating, understanding them will help traders form a unique edge in their trading journey.
In the coming post, we'll learn more about seasonality in butterfly spread, stay tuned!
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Disclaimers
Any of the information above is produced with my own best effort and research.
This post is produced purely for sharing purposes and should not be taken as a buy/sell recommendation. Past return is not indicative of future performance. Please seek advice from a licensed financial planner before making any financial decisions.
Leverage is a financial tool that comes with its advantages and risks. Please learn and understand both the upsides and downsides of leverage before using it for trading.
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