Trading butterflies can be a great approach to directional option trading.  They offer defined reward and risk and usually involve a lower level of outright dollar allocation to any particular trade.  They can also offer some potential pitfalls if you are not careful as well.  If you make a directional bet and are “too right” directionally, you could end up losing. 

First let’s break down what a butter fly really is.  It is, simply, two vertical spreads transacted at the same time with one spread “financing” the other.  This is why the cost basis for these types of trades tends to be lower in price. You do, however, run the risk of “blowing through” all of your strikes and forfeiting your initial debit to put on the spread. 

You can counter act this by doing what I term a “broken-wing” butterfly.  This is a butterfly done in the usual way, but instead of having a symmetrical spacing between the strikes, the front end is skewed wider.  This alleviates the risk of being “too right,” but it too has its drawbacks. 

The biggest drawback is that these spreads tend to cost more than a symmetrical butterfly. Take NFLX as an example.  On Monday morning, NFLX was trading about $420.00 after getting a downgrade from Evercore, and it was hammered down to its 200-day moving average where it found support. This offered a great opportunity to get long a stock that has not offered up too many value entry points. 

I signaled to purchase the NFLX April 450/470/480 call butterfly for $3.00.  This can be broken down into two parts.  One is the purchase of the April 450/470 call spread while simultaneously selling the April 470/480 call spread.  So, I can make $20 on the front call spread (less our $3 in premium paid) and only lose $10 on the back one.  So, the ideal place to be at expiration is at $470.  That maximizes the gain, and minimizes the loss. 

The reward to risk here is a very impressive 5.67:1 ((20-3)/3) at $470 and still 2.33:1 ((10-3)/3), if I blow through my strikes.  Of course, the entire $3 initial investment is at risk should the price not get above $450 by expiration.