Butterfly Spread Explained

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Butterfly Spread Explained (Simple Guide)

How would you like to earn a positive return if you think a stock is going to stay flat or swing wildly in either direction over the short term? If so, then you should check out the butterfly spread.

A butterfly spread is a multi-leg options strategy that involves either a short or a long position.

If you go short, then you’re anticipating the underlying stock to swing up or down in price in the near future.

If you go long, then you’re anticipating the underlying stock price to stay flat in the near future.

In either case, it’s a limited risk, limited profit strategy.

In this guide, I’ll explain the butterfly spread so you can make an informed decision about using it in your options trades.

What Is a Butterfly Spread ?

A butterfly spread involves opening four trades: two of them are buys and two of them are sells.

If you’re opening a long butterfly position, you’ll buy one out-of-the-money option, sell two at-the-money options, and buy one in-the-money option. In that case, you make money when the price of the underlying stock stays roughly the same.

If you’re opening a short butterfly position, you’ll do the exact opposite: sell one out-of-the-money option, buy two at-the-money options, and sell one in-the-money option. In that case, you make money when the price of the underlying stock goes above the higher strike price or below the lower strike price.

You can structure a butterfly spread with call options or put options. It works the same either way as long as all the options in the trade are the same. In other words, they must all be call options or all put options.

Another important point: the in-the-money and out-of-the-money options must be equidistant in strike price from the at-the-money option.

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For example, if you buy two $60 at-the-money call options for a short spread, then you can keep the butterfly in balance by selling the $55 in-the-money call option and $65 out-of-the money call option. That’s because both of those options are exactly $5 away from the $60 strike price of the at-the-money options.

When Would You Use a Butterfly Spread ?

Use a butterfly spread when you think the price of the underlying stock is going to stay flat or swing significantly in either direction.

If you think the stock is going to stay flat, opt for a long butterfly spread.

If you think the stock is going to move up or down by a wide margin, opt for a short butterfly spread.

It’s also worth noting that a butterfly spread is a complicated strategy that’s best suited for experienced traders. If you’re just getting started out, make sure you do plenty of practice trading with butterfly spreads before you start working with real money.

How Does a Butterfly Spread Work?

Before you can enter into a butterfly spread, make sure that your trading platform supports multi-leg orders. Don’t even think about trying a butterfly spread without that ability. You could lose a lot of money.

Once you’ve established that your online brokerage supports multi-leg trades, it’s easy to place the order.

First, determine whether you’re going long or short with the butterfly spread. See above for info on that.

If you’re going long:

  • Buy an out-of-the-money option
  • Sell two at-the-money options
  • Buy an in the money option

If you’re going short:

  • Sell an out-of-the-money option
  • Buy two at-the-money options
  • Sell an in-the-money option

After you’ve established your trading direction, open the appropriate positions one at a time. Make sure you review your whole trade before you finally “pull the trigger.” Mistakes in options trading can be very expensive.

A long transaction will result in a debit to your account (meaning you’ll pay for it). A short transaction will result in a credit to your account (meaning you’ll receive money).

Real Life Example Using a Butterfly Spread ?

Let’s say that Bank of America is trading at $28.50 per share. You think it’s going to stay flat over the next month, so you decide to open a long butterfly spread.

You start by buying next month’s $26 call option for $2.64. That costs you $264 since options contracts trade in groups of 100 shares ($2.64 x 100).

Next, you sell two at-the-money call options. They’re currently trading for $0.74 each, so that earns you $148 ($0.74 x 2 x 100).

Finally, you buy the $31 call option for $0.07. That costs you only $7 ($.07 x 100).

So your total debit for the whole transaction is $264 – $148 + $7 = $123. That’s also your maximum loss for this butterfly spread.

Let’s assume your prediction was accurate. During the course of the next month, Bank of America shares hover around $28.50. What happens?

Remember, the whole point of a long butterfly spread is to profit when the stock price doesn’t move much.

If Bank of America is near $28.50 as you move close to expiration, the in-the-money call options will drop a bit in price to around $2.20.

However, the at-the-money options will decrease in value to $.10 per contract from the original price of $0.74 per contract. That’s okay, though, because you were short those options. You want them to go down in value.

The out-of the money call option will expire worthless.

Let’s run the numbers: You lost $0.44 on the in-the-money option ($2.64 – $2.20). You made $1.28 on the at-the-money options ($0.74 – $0.10 x 2). You lost $0.07 on the out-of-the-money option.

So your total profit for the trade is $1.28 – $0.44 – $0.07 or $0.77.

Remember, though, that options contracts trade in groups of 100 shares so your profit is really $77 ($0.77 x 100).

Here are a couple of strategies similar to a butterfly spread:

  • Neutral Calendar Spread – Involves buying long-term call options while selling the same amount of near-term at-the-money or slightly out-of-the-money call options.
  • Iron Condor – Involves buying an out-of-the-money call option, selling an out-of-the-money call option at a lower strike price, buying an out-of-the-money put option, and selling an out-of-the-money put option at a higher strike price.Click here to read more about Iron Condors.

Butterfly Spread Compared to Other Options Strategies?

A butterfly spread is a limited-risk, limited-profit strategy. As such, it joins countless other options strategies that use spreads to mitigate both risk and profit.

Keep in mind, though: when you’re dealing with “limited” risk or profit in options trading, you can still earn a high return or lose a lot of money relative to the amount you invest.

Butterfly Spread

What Is a Butterfly Spread?

A butterfly spread is an options strategy combining bull and bear spreads, with a fixed risk and capped profit. These spreads, involving either four calls or four puts are intended as a market-neutral strategy and pay off the most if the underlying does not move prior to option expiration.

Key Takeaways

  • There are multiple butterfly spreads, all using four options.
  • All butterfly spreads use three different strike prices.
  • The upper and lower strike prices are equal distance from the middle, or at-the-money, strike price.
  • Each type of butterfly has a maximum profit and a maximum loss.

Understanding Butterflies

Butterfly spreads use four option contracts with the same expiration but three different strike prices. A higher strike price, an at-the-money strike price, and a lower strike price. The options with the higher and lower strike prices are the same distance from the at-the-money options. If the at-the-money options have a strike price of $60, the upper and lower options should have strike prices equal dollar amounts above and below $60. At $55 and $65, for example, as these strikes are both $5 away from $60.

Puts or calls can be used for a butterfly spread. Combining the options in various ways will create different types of butterfly spreads, each designed to either profit from volatility or low volatility.

Long Call Butterfly

The long butterfly call spread is created by buying one in-the-money call option with a low strike price, writing two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. Net debt is created when entering the trade.

The maximum profit is achieved if the price of the underlying at expiration is the same as the written calls. The max profit is equal to the strike of the written option, less the strike of the lower call, premiums, and commissions paid. The maximum loss is the initial cost of the premiums paid, plus commissions.

Short Call Butterfly

The short butterfly spread is created by selling one in-the-money call option with a lower strike price, buying two at-the-money call options, and selling an out-of-the-money call option at a higher strike price. A net credit is created when entering the position. This position maximizes its profit if the price of the underlying is above or the upper strike or below the lower strike at expiry.

The maximum profit is equal to the initial premium received, less the price of commissions. The maximum loss is the strike price of the bought call minus the lower strike price, less the premiums received.

Long Put Butterfly

The long put butterfly spread is created by buying one put with a lower strike price, selling two at-the-money puts, and buying a put with a higher strike price. Net debt is created when entering the position. Like the long call butterfly, this position has a maximum profit when the underlying stays at the strike price of the middle options.

The maximum profit is equal to the higher strike price minus the strike of the sold put, less the premium paid. The maximum loss of the trade is limited to the initial premiums and commissions paid.

Short Put Butterfly

The short put butterfly spread is created by writing one out-of-the-money put option with a low strike price, buying two at-the-money puts, and writing an in-the-money put option at a higher strike price. This strategy realizes its maximum profit if the price of the underlying is above the upper strike or below the lower strike price at expiration.

The maximum profit for the strategy is the premiums received. The maximum loss is the higher strike price minus the strike of the bought put, less the premiums received.

Iron Butterfly

The iron butterfly spread is created by buying an out-of-the-money put option with a lower strike price, writing an at-the-money put option, writing an at-the-money call option, and buying an out-of-the-money call option with a higher strike price. The result is a trade with a net credit that’s best suited for lower volatility scenarios. The maximum profit occurs if the underlying stays at the middle strike price.

The maximum profit is the premiums received. The maximum loss is the strike price of the bought call minus the strike price of the written call, less the premiums received.

Reverse Iron Butterfly

The reverse iron butterfly spread is created by writing an out-of-the-money put at a lower strike price, buying an at-the-money put, buying an at-the-money call, and writing an out-of-the-money call at a higher strike price. This creates a net debit trade that’s best suited for high-volatility scenarios. Maximum profit occurs when the price of the underlying moves above or below the upper or lower strike prices.

The strategy’s risk is limited to the premium paid to attain the position. The maximum profit is the strike price of the written call minus the strike of the bought call, less the premiums paid.

Example of a Long Call Butterfly

An investor believes that Verizon stock, currently trading at $60 will not move significantly over the next several months. They choose to implement a long call butterfly spread to potentially profit if the price stays where it is.

An investor writes two call options on Verizon at a strike price of $60, and also buys two additional calls at $55 and $65.

In this scenario, an investor would make the maximum profit if Verizon stock is priced at $60 at expiration. If Verizon is below $55 at expiration, or above $65, the investor would realize their maximum loss, which would be the cost of buying the two wing call options (the higher and lower strike) reduced by the proceeds of selling the two middle strike options.

If the underlying asset is priced between $55 and $65, a loss or profit may occur. The amount of premium paid to enter the position is key. Assume that it costs $2.50 to enter the position. Based on that, if Verizon is priced anywhere below $60 minus $2.50, the position would experience a loss. The same holds true if the underlying asset were priced at $60 plus $2.50 at expiration. In this scenario, the position would profit if the underlying asset is priced anywhere between $57.50 and $62.50 at expiration.

This scenario does not include the cost of commissions, which can add up when trading multiple options.

Butterfly Spread

The butterfly spread is a neutral strategy that is a combination of a bull spread and a bear spread. It is a limited profit, limited risk options strategy. There are 3 striking prices involved in a butterfly spread and it can be constructed using calls or puts.

Butterfly Spread Construction
Buy 1 ITM Call
Sell 2 ATM Calls
Buy 1 OTM Call

Long Call Butterfly

Long butterfly spreads are entered when the investor thinks that the underlying stock will not rise or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower striking in-the-money call, writing two at-the-money calls and buying another higher striking out-of-the-money call. A resulting net debit is taken to enter the trade.

Limited Profit

Maximum profit for the long butterfly spread is attained when the underlying stock price remains unchanged at expiration. At this price, only the lower striking call expires in the money.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Short Call – Strike Price of Lower Strike Long Call – Net Premium Paid – Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Short Calls

Limited Risk

Maximum loss for the long butterfly spread is limited to the initial debit taken to enter the trade plus commissions.

The formula for calculating maximum loss is given below:

  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying = Strike Price of Higher Strike Long Call

Breakeven Point(s)

There are 2 break-even points for the butterfly spread position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Strike Price of Higher Strike Long Call – Net Premium Paid
  • Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader executes a long call butterfly by purchasing a JUL 30 call for $1100, writing two JUL 40 calls for $400 each and purchasing another JUL 50 call for $100. The net debit taken to enter the position is $400, which is also his maximum possible loss.

On expiration in July, XYZ stock is still trading at $40. The JUL 40 calls and the JUL 50 call expire worthless while the JUL 30 call still has an intrinsic value of $1000. Subtracting the initial debit of $400, the resulting profit is $600, which is also the maximum profit attainable.

Maximum loss results when the stock is trading below $30 or above $50. At $30, all the options expires worthless. Above $50, any “profit” from the two long calls will be neutralised by the “loss” from the two short calls. In both situations, the butterfly trader suffers maximum loss which is the initial debit taken to enter the trade.

Note: While we have covered the use of this strategy with reference to stock options, the butterfly spread is equally applicable using ETF options, index options as well as options on futures.

Commissions

Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the butterfly spread as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.

If you make multi-legged options trades frequently, you should check out the brokerage firm OptionsHouse.com where they charge a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the butterfly spread in that they are also low volatility strategies that have limited profit potential and limited risk.

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