I am often asked about exotic option trades. Mainly because they seem to have solid reward to risk characteristics.

The problem is that they are difficult to implement and usually not cost effective. They only make sense occasionally if you are expecting a specific move or tight trading range for the underlying stock.

In May 2008, I talked about the so-called butterfly spread. In its most basic form, the butterfly is a combination that includes a bull call spread and a bear call spread. It is designed to make money if the underlying stock remains in a relatively narrow trading range. What makes it interesting is that your risk is limited even if the stock goes outside its range.

There are three legs to the butterfly spread; 1) a long in-the-money call, 2) a long out-of-the-money call and 3) two short at-the-money calls.

For example, Agrium (TSX: AGU) closed on Friday at $85.21. If you expected AGU to remain in a trading range between now and the December expiration, you could buy one AGU December 74 call at $12, sell two AGU December 84 calls at $4.50, and buy one AGU December 94 call at $1.25.

If we leave aside commissions, this trade has a net out-of-pocket cost of $4.25 per share. That is, $13.25 for the purchase of the Dec 74 call and the Dec 94 call. The sale of the two December 84 calls generates $9.00 per share in income. The difference being $4.25, which is also the most you can lose with this trade.

The maximum profit occurs if the stock closes exactly at $84 at the December expiration. In the unlikely event that happened, the AGU Dec 74 call would be worth $10 per share and the remaining options would expire worthless. On a $4.25 net outlay, that translates into a 135% return… if we ignore transaction costs.

The risk is limited because the two long calls offset the two short calls. Suppose AGU closes at $100 at the December expiration. Your two short December 84 calls would be worth $16 each or $32 on the total position.

However, your December 74 call would be worth $26 per share and the December 94 call would be worth $6. Total value of the long options is also $32, which means that your net loss would be the initial $4.25 outlay.

Same thing on the downside. If AGU was at $50 per share at the December expiration, all the options would expire worthless, and you net loss would be the $4.25 per share initial outlay.

This trade is profitable if the stock closes between $78.25 ($74 strike price + $4.25 debit = $78.25) and $89.75 ($94 strike price less $4.25 debit = $89.75) at the December expiration. Which means the reward to risk ratio is 1.35 to 1. If as I said, we ignore transaction costs.

The downside of course is transaction costs. Twenty years ago, costs would have been prohibitive. Today, with discount fees, the trade can be implemented, but with three trades to enter and potentially three trades to exit, costs – including the spread between the bid and offered price – remain a major consideration.

For average traders, exotic trades rarely make sense. Especially when you factor in costs. On rare occasions where the trade seems reasonable, make certain to get a reward to risk ratio of 2.5 to 1 or better.