What is Butterfly Spread?
Butterfly Spread is a trading option comprising both bull spread and bear spread, allowing investors to follow a limited profit, limited risk investment strategy. It is a neutral options strategy for traders who want a trade-off between profits and risks.
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This options strategy consists of different call or put options on the same underlying asset with the same expiration date but with different Strike or exercise prices. It involves three strike prices to carry out four trades altogether. The investors can either take four butterfly call options or four butterfly put options, or a combination of both.
Table of contents
- What is Butterfly Spread?
- Butterfly Spread Options Explained
- Butterfly vs Straddle
- Types of Butterfly Spread Options
- #1 – Long call butterfly
- #2 – Short call butterfly
- #3 – Long put butterfly
- #4 – Short put butterfly
- #5 – Iron butterfly
- #6 – Reverse iron butterfly
- Examples of Butterfly Spread
- Example #1
- Example #2
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- Butterfly spread is a trading strategy that involves open call or put options at a one strike price offset by transactions at a higher and a lower strike price simultaneously.
- This strategy yields a finite profit or results in a limited loss.
- It consists of one call/put option at a lower strike, two call/put trades at a middle strike, and one call/put option at a high strike price.
- A butterfly spread is different from a straddle, which includes two transactions related to the same asset, with one having a long risk and the other having a short risk involved.
- Types of butterfly spread options include long call, short call, long put, short put, iron, and reverse iron.
Butterfly Spread Options Explained
Butterfly spread options strategy offers traders a neutral attempt to profit from options trading. Here investors open a call or put option and add other calls or puts to protect their position if the stock moves in a direction other than expected. This trading strategy derives its name from the structure formed after plotting all trading options on a graph, which resembles a butterfly.
This strategy includes one call/put at a lower strike, two call/put trades at a middle strike, and one call/put option at a higher strike price. Note that the underlying security or asset is the same with the same expiration date. The higher and lower strike prices in a butterfly spread are at an equal distance from the middle strike price.
Suppose an investor uses this strategy and buys a call of 2285, sells two 2310 calls, and purchases a 2335 call of the same security with the same expiration. A butterfly structure forms by arranging this data on a graph. While 2285 and 2335 positions are the butterfly’s wings in this example, the 2310 position is its body.
The butterfly spread option works the best in a non-directional market, where the security prices are less volatile. In such a scenario, the underlying asset price equals the middle strike price when the spread option nears the expiration period.
Thus, the investors profit if they assume that prices will stagnate. However, if the prices fluctuate, then also the wings check their losses. As a result, the spread option limits the profit and risks, letting investors tread cautiously.
Types of Butterfly Spread Options
The butterfly spread options appear in different forms:
#1 – Long call butterfly
Investors enter these spreads when they think the underlying stock price will not fluctuate on expiration. In this strategy, traders:
- Buy 1 call option with a lower strike price
- Sell 2 call options with a middle strike price
- Buy 1 call with a higher strike price
All call options have the same underlying security and expiration date. The investors make a maximum profit if the security price equals the middle strike price on the expiration date.
#2 – Short call butterfly
Under this butterfly strategy, traders:
- Sell 1 call option with a lower strike price
- Buy 2 call options with a middle strike price
- Sell 1 call with a higher strike price
Investors can maximize their profit if the security price is more than the higher strike price or less than the lower strike price on expiration.
#3 – Long put butterfly
This butterfly spread occurs when investors:
- Buy 1 put with a lower strike price
- Sell 2 puts with a middle strike price
- Buy 1 put with a higher strike price
Investors reap maximum profit when the security price is equal to the middle strike price on the expiration date.
#4 – Short put butterfly
The short put butterfly forms when investors:
- Sell 1 put with a lower strike price
- Buy 2 puts with a middle strike price
- Sell 1 put with a higher strike price
Traders can make maximum profit when the security price is more than the higher strike price or less than the lower strike price on the expiration date.
#5 – Iron butterfly
Under this strategy, investors buy and sell a combination of call and put trades. They undertake the following trades:
- Buy 1 put with a lower strike price
- Sell 1 put with a middle strike price
- Sell 1 call with a middle strike price
- Buy 1 call with a higher strike price
Traders attain maximum profit when the price of the underlying security is equal to the middle strike price on expiration.
#6 – Reverse iron butterfly
The reverse or short iron butterfly is a limited risk, limited profit strategy. Investors use it when the underlying securities are likely to make a sharp upward or downward move. It forms when traders:
- Sell 1 put with a lower strike price
- Buy 1 put with a middle strike price
- Buy 1 call with a middle strike price
- Sell 1 call with a higher strike price
Maximum profit occurs when the security price is more than the lower strike price and less than the higher strike price on expiration.
Examples of Butterfly Spread
Let’s consider the following butterfly spread examples to understand the concepts better:
Example #1
Suppose investor A buys stocks of company XYZ, trading at $50. As the investor thinks the prices will fluctuate in the next few months, A chooses to go for a short call butterfly spread. Accordingly, the trader buys two call options at a strike price of $50 while selling two call options at $45 and $55.
He pays $7 as a premium to buy two call options at $50 and receives $7 and $1 premiums for selling call options at $45 and $55. Thus, his net income to enter these positions comes out to be $1 ($7+$1-$7).
As a result, the maximum profit that A can make is $1 if the stock price is above $55 or below $45 on expiration. However, he may incur a loss if the stock price equals the middle strike price of $50 on expiration. But, then also, this strategy limits the losses to $4 ($5-$1), where the difference between the lower and middle strike prices is $5 ($50-$45), and the net income received is $1. Thus, this strategy comes with defined profits and risks.
Example #2
Stephens invests in Apple stocks, trading at $180. He expects the stock prices to stagnate and hence opts for a long call butterfly spread. Therefore, he writes two call options at a strike price of $180 and buys two call options at $170 and $190. This way, he knows his profit or loss limit if the price moves below or above the maximum limit.
When traders enter a trade, they have to pay a premium. In this case, Stephens pays and receives the following premium:
- To buy 1 Apple stock at $170, he pays a $5 premium
- To sell 2 Apple stocks at $180, he receives a $6 premium ($3 each)
- To buy 1 Apple stock at $190, he pays a $2 premium
So, Stephens incurs net cost of $1 to enter into these positions.
Net cost = $6 – $5 – $2 = ($1)
Therefore, $1 is the maximum amount of loss he incurs if the stock price is more than $190 or less than 170 at expiration. However, if the stock price remains at $180, his maximum profit is $9, i.e., $10 ($180-$170) minus $1 (net cost incurred to enter into these positions). Thus, this strategy caps both profits and losses.
Butterfly vs Straddle
A butterfly spread strategy is different from a straddle. A straddle involves simultaneously buying or selling a call and a put option related to the same asset with the same expiry date and exercise price. Under straddle, there is only one strike price as against three in the case of butterfly.
Investors use straddle when they expect a substantial stock price movement. In contrast, they prefer butterfly when markets are less volatile. Unlike the butterfly strategy, which restricts the profit or loss prospects, straddle comes with an unlimited profit or loss potential.
The breakeven points, which mark the point where payoffs are equal to the original premium, are different for both. For the straddle strategy, the breakeven point is obtained by adding/subtracting the premiums received to/from the strike price.
On the other hand, the breakeven point for butterfly spreads is obtained by either adding the lower strike price to the premium paid or subtracting the premium paid from the upper strike price.
Frequently Asked Questions (FAQs)
Butterfly Spread is a trading option comprising different options on the same underlying security with the same expiration but with different strike prices. It is a finite profit and limited risk investment strategy. It involves three strike prices to carry out four trades altogether. The investors can either take four call options or four put options, or a combination of both.
There are different types of butterfly spread options. Some of them are: long call, short call, long put, short put, iron butterfly, and reverse iron butterfly. The butterfly spread strategy involves long and short positions in call or put options at different strike prices. All options are put for put butterfly and all options are call for call butterfly.
A straddle includes two transactions related to the same asset, with one having a long risk and the other having a short risk involved. Butterfly spreads often are created when a single open position is extended by adding other call or put options at different strike prices. Under the straddle strategy, the investors can gain unlimited profit but incur huge losses as well. But in the butterfly strategy, though the profits are limited, the losses are also curbed by the wings.
Recommended Articles
This has been a guide to What is a Butterfly Spread. We discuss types of butterfly spread options strategy like long, short, put & call along with examples. You can learn more from the following articles –
- Options Trading
- Options Spread
- Bermuda Options
This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here
