What Is a Butterfly Spread?
The butterfly spread is an options strategy that balances bull and bear spreads, offering fixed risk and capped profit potential. Designed as a market-neutral method, this strategy shines when the underlying asset remains stable until the option expires. It involves four options—calls, puts, or a mix—across three strike prices.
Key Takeaways
- Combines bull and bear spreads for a balanced options strategy.
- Market-neutral, with fixed risk and capped returns.
- Thrives when the underlying asset remains stable until expiration.
- Uses four options at three distinct strike prices.
- Strike prices equally spaced from the center, at-the-money point.
Understanding Butterfly Spreads
Butterfly spreads cater to options traders seeking stability. An option is a financial instrument tied to an underlying asset like a stock or commodity, enabling buyers to execute transactions by a specified expiration date.
Combining both bull and bear spreads, a butterfly spread leverages four options contracts with a shared expiration and three varied strike prices:
- Higher strike price
- At-the-money strike price
- Lower strike price
The higher and lower strike prices maintain equal distances from the at-the-money strike. For instance, if at-the-money is $60, the other strikes should be symmetrically higher and lower—$55 and $65. Both calls and puts can configure a butterfly spread, shifting it towards profit from either volatility or stability.
Types of Butterfly Spreads
Long Call Butterfly Spread
Involves buying one in-the-money call, writing two at-the-money calls, and buying one out-of-the-money call. Enters the trade with a net debit. Profit peaks if the underlying price matches the written calls at expiration, with maximum losses limited to the initial premiums.
Short Call Butterfly Spread
Formed by selling one in-the-money call, buying two at-the-money calls, and selling one out-of-the-money call. Generates a net credit. Maximizes profit if the underlying trades above the upper strike or below the lower strike at expiration, with loss constrained by the premium received.
Long Put Butterfly Spread
Involves buying one put at a lower strike, selling two at-the-money puts, and buying a higher strike put. Enters the position with net debt and seeks maximum profit when the underlying remains at the middle strike price by expiration.
Short Put Butterfly Spread
Created by selling one out-of-the-money put, buying two at-the-money puts, and selling an in-the-money put. Realizes profit if the underlying lies outside the strike bounds at expiration. The risk remains within the premiums received.
Iron Butterfly Spread
Integrates one out-of-the-money put, one at-the-money put, one at-the-money call, and one out-of-the-money call. Ideal for low volatility, the strategy brings net credit. Maximum profits occur at the middle strike price, with losses confined by premium subtractions.
Reverse Iron Butterfly Spread
Combines selling an out-of-the-money put, buying an at-the-money put, buying an at-the-money call, and selling an out-of-the-money call. Suitable for high volatility, this net debit strategy profits when the price surpasses the strike bounds.
Example of a Long Call Butterfly Spread
Consider Verizon (VZ) trades at $60. Expecting minimal movement, an investor executes a long call butterfly spread for potential gains. By writing two $60 strike call options and buying a $55 call and a $65 call, the maximum profit occurs if Verizon stays at $60 until expiration. The loss peaks if the price significantly deviates from $55 or $65.
Assuming an initial cost of $2.50, profit occurs when Verizon prices between $57.50 and $62.50 at expiration, excluding commission costs.
Characteristics of a Butterfly Spread
Comprising four options contracts with the same expiration but three distinct strike prices, the butterfly spread ranges through higher, at-the-money, and lower strikes. Maximum profit and loss are confined. For alternative strategies, the Christmas tree involves six options contracts.
Constructing a Long Call Butterfly Spread
Buy one in-the-money call, sell (write) two at-the-money calls, and buy one out-of-the-money call, creating net debt. Maximum profit is reached if the asset price at expiration meets the strike of the written calls, whereas losses are limited to the initial premium payments.
Constructing a Long Put Butterfly Spread
Buy one out-of-the-money put, sell (write) two at-the-money puts, and buy one in-the-money put, also creating net debt. Profits peak if the underlying asset resides at the central strike price. Maximum losses align with initial premiums and commissions.
Related Terms: option strategy, bull spread, bear spread, iron butterfly spread, reverse iron butterfly spread.
References
- Financial Industry Regulatory Authority. “Options”.
