I do not have a source for this (apologies), but sometimes, I hear about option traders initiating a vertical spread(short) and then converting that call spread to a butterfly spread to mitigate risk.

I understand the different legs of a butterfly, but it is not obvious to me how morphing a vertical call spread to a butterfly call spread helps reduce the risk ?

  • $\begingroup$ Many of your questions are really about different plays on the option greeks - I think you should really read the references I gave you first and most of your questions will be answered! $\endgroup$ – vonjd Mar 2 '15 at 9:14
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    $\begingroup$ Point noted, will do! $\endgroup$ – Victor123 Mar 2 '15 at 15:34

Conversion to a butterfly can mitigate or even eliminate all risk taken by opening a initial debit spread or long option position. This is possible only if the underlying moved in your favor after your initial position is open. To convert to a butterfly you simply sell and buy enough options (for a credit) that together with your initial position forms a butterfly. The credit taken in offsets all or most of your debit to open the initial position. Thus your risk is eliminated. This technique is a staple used by all Market Makers. For a specific example of a trade which ends up converted to a butterfly with charts see converting options spread to butterfly. (disclosure: I am affiliated with the site)

PS: Quant is not place for trading related questions. This is mostly a place for people to geek out about options.

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  • $\begingroup$ Thanks. I was getting that impression too...i guess i better head over to elite trader lol...thank you so much $\endgroup$ – Victor123 Mar 2 '15 at 18:53
  • $\begingroup$ Also, if the trade moved in my favor, i can just move my stop loss to my entry point and thus mitigate all risk, no? Why need for a butterfly? $\endgroup$ – Victor123 Mar 2 '15 at 18:56
  • $\begingroup$ Thanks for the link. So you bought a put and then did call butterfly against that put? $\endgroup$ – Victor123 Mar 2 '15 at 21:46
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    $\begingroup$ A put butterfly, but it makes no difference. There are 3 ways to do butterflies. All calls, all puts and mixed put/call, aka iron butterfly $\endgroup$ – baerrus Mar 2 '15 at 23:22
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    $\begingroup$ Why use butterflies? - Imagine yourself as a market maker. You are holding 100s or 1000s of open options positions. You already gotten your profit from bid/ask spread. Now you are sitting and waiting to eliminate your risk. As soon as the underlying moves, you want to lock in the profit but not close the position outright. So you convert to a butterfly.By expiration no matter where the underlying is you either have a profit or zero. $\endgroup$ – baerrus Mar 2 '15 at 23:28

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