Futures Butterfly Spreads


Butterfly Spreads - Definition


Butterfly Spreads are complex futures spreads that combine a near term bull spread with a longer term bear spread in order to profit from a change in term structure.


Butterfly Spreads - Introduction


Futures Butterfly Spreads, better known for its options version, is the most complex spreading strategy in futures trading. Futures butterfly spreads are used by the most veteran futures traders when they are of the opinion that mid term futures prices are going to drop while short term and long term futures prices are going to remain stagnant or rise. Such change in term structures are common seasonal behaviors of certain commodities and it takes experienced futures traders to identify and time such changes.

This tutorial shall explore in depth what Butterfly Spreads are, their working mechanism as well as their pros and cons in futures trading. (p/s were you looking for Options Butterfly Spread?)


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What Exactly Are Butterfly Spreads?


While futures bull spreads and bear spreads use only futures contracts from two different expiration months, futures butterfly spreads use futures contarcts from three different expiration months. In fact, futures butterfly spreads are a combination of a bull spread and a bear spread with the short leg centered on the same calendar month. This forms a futures position with two long wings and one short body, which is how the name "Butterfly Spread" came about.

So, a futures butterfly spread is formed when you:

Long 1 X Near Term + Short 2 X Mid Term + Long 1 X Further Term

Futures Butterfly Spread Example

Assuming S&P500 is at 1100 and its Jun2010 E-mini futures contract is asking for 1099.5, its Dec2010 E-mini futures contract is asking for 1096 and its Jun2011 E-mini futures contract is asking for 1093.

You create a butterfly spread by going long on 1 contract of the Jun2010, simultaneously go short on 2 contracts of the Dec2010 and go long on 1 contract of the Jun2011.

This butterfly spread position actually consists of a Jun2010/Dec2010 bull spread and a Dec2010/Jun2011 bear spread.


The futures butterfly spread is an extremely unique futures spread strategy because it is a spread strategy that bets on the "Term Structure" of futures contracts rather than the direction of the underlying asset.



How Does Butterfly Spreads Make A Profit?


Unlike outright futures trading positions which make a profit only when the futures contracts that you own appreciate or depreciate in value, futures Butterfly Spreads profit when:

1. When both long legs rise and short leg falls.

2. When both long legs rise and short leg remains unchanged.

3. When both long legs rise and short leg rises at a lower rate.

4. When short leg falls faster than both long legs.

5. When both long legs remain unchanged and short leg falls.

6. When the near term long leg rises and all other legs remain stagnant.

7. When the far term long leg rises and all other legs remain stagnant.

8. When the near term long leg rises more than the short leg rises and far term long leg falls.

9. When the far term long leg rises more than the short leg rises and near term long leg falls.

10. When the near term long leg rises more than the far term long leg falls with short leg remaining stagnant.

11. When far term long leg rises more than the near term long leg falls with short leg remaining stagnant.



Why Use Butterfly Spreads?


Futures butterfly spreads are specifically used for speculating on changes in the term structure of futures contracts rather than on the movements on the underlying asset itself. However, understanding term structure changes requires experience with a single market for extended periods of time and is not usually undertaken by retail futures traders.

Futures traders speculating that mid term futures contracts will decline against short term and longer term ones could use the butterfly spread in order to dramatically reduce margin requirements and also open up a lot more avenues to profit than an outright short position on mid term futures contracts as you can see in the previous section.



When To Use Futures Butterfly Spreads


Generally you would use butterfly spreads when you expect prices of mid term futures contracts to fall relative to short term and/or long term futures contracts, changing the shape of the term structure. Such changes to term structure can happen in both a normal or inverted market due to mid term shifts in supply/demand or other seasonal factors.

Futures Butterfly Spread Profit Scenarios





Advantages of Butterfly Spreads



:: Much more avenues of profit than an outright futures position, hence higher probability of profit.

:: Butterfly Spreads lowers margin requirement thereby increasing your ROI.



Disadvantages of Butterfly Spreads



:: More legs take up more commission

:: Analysis of term structure changes can be much more complex than analysis of price changes in the underlying asset.





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