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Being relatively new to options, I’m paper trading various strategies until I thoroughly understand them and commit real capital. One position that’s stumped me is a long butterfly using two contracts (2 x (4) x 2) purchased for $1.00. The stock proceeded to dive shortly thereafter and much to my surprise, instead of a maximum loss I thought was contained to $200, the position was down more than $1,200! Can you help explain this to a slightly disconcerted newbie?

First, let’s start off with a bit of congratulations on your willingness to learn the mechanics of option trading and smart sense to utilize your broker’s paper trading platform as an integral part of that process. As for your long butterfly position, it sounds as though you have a modified version of this spread, with a larger embedded, sold vertical as your likely profit & loss culprit.

Say what? Know this: a long butterfly can have a unique risk profile with greater losses than the initial debit if the purchased vertical (either lower bull call spread or higher bear put spread) is tighter than the sold vertical component. Similarly, long butterflies can be modified with different ratios such as 1 x (3) x 2 with equal strike distances for the verticals and yield similar lopsided risk on one side of the spread.

When a butterfly goes deep in-the-money, quoted markets can be wider than normal and cause the position to show an exaggerated loss.In regards to your dilemma, the modification is often called a “broken wing butterfly.” The profit center of the butterfly, just like a regular fly, is the purchased spread minus the initial debit. But the bear call spread or bull put spread sold is designed using a wider strike distance. The result is the associated risk with that vertical will siphon the long vertical’s profits by the extra difference of the larger spread if shares jump above or below that vertical’s purchased outer wing.

For instance, if a trader purchased one — that is, (1 x (2) x1) 30/27.5/22.5 put butterfly — for $0.50, the maximum profit is the 2.5-point 30/27.5 bear put spread minus the debit. This produces $2.00 in profit at expiration if shares are exactly at the 27.5 strike. The downside is this position’s maximum loss is $3.00, or $2.50 more than the price paid for the butterfly. This is because the design of this butterfly maintains a five-point 27.5/22.5 bull put spread whose risk is double the profit of the bear put spread.

It should be noted that losses larger than what we expect from a butterfly can sometimes be attributed to temporary distortions in implieds during an abrupt move in the underlying. When a butterfly goes deep in-the-money, quoted markets can be wider than normal and cause the position to show an exaggerated loss. However, that influence isn’t going to be of the magnitude of loss with which you’re obviously concerned. Ultimately, your profit center spread would be favorably affected by the same market forces and should mostly offset the increased (paper) risk of the other component short vertical.

Similarly, if the butterfly is deep in-the-money in a stock that’s hard to borrow, the quoted markets will tend to be wide and illiquid. We’d strongly suggest staying away from those type of situations, as put/call parity doesn’t necessary hold up as it would otherwise due to the problems associated with maintaining or executing short stock. Free information is available on many financial sites online regarding current short interest statistics. In addition, your broker should be able to provide you with information and advice regarding stocks with this kind of exceptional and unwanted risk.

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