Butterfly Spread
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Butterfly Spread
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The Options Guide
Outlook on Underlying:
Arbitrage
Bearish
Bullish
Neutral - Bearish on Volatility
Neutral - Bullish on Volatility
Profit Potential:
Limited
Unlimited
Loss Potential:
Limited
Unlimited
Credit/Debit:
Credit
Debit
No. Legs:
1
2
3
4
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 .
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.
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:
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:
There are 2 break-even points for the butterfly spread position. The breakeven points can be calculated using the following formulae.
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 .
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).
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.
The converse strategy to the long butterfly is the short butterfly. Short butterfly
spreads are used when high volatility is expected to push the stock price in either
direction.
The long butterfly trading strategy can also be created using puts instead of calls and is known as a long put butterfly .
The butterfly spread belongs to a family of spreads called
wingspreads whose members are named after a myriad of flying creatures.
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Many a times, stock price gap up or down following the quarterly earnings report
but often, the direction of the movement can be unpredictable. For instance, a sell
off can occur even though the earnings report is good if investors had expected
great results.... [Read on...]
If you are very bullish on a particular stock for the long term and is looking to
purchase the stock but feels that it is slightly overvalued at the moment, then
you may want to consider writing put options on the
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then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®....
[Read on...]
Cash dividends issued by stocks have big impact on their option prices. This is
because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date.... [Read on...]
As an alternative to writing covered calls, one can enter a bull call spread for
a similar profit potential but with significantly less capital requirement. In
place of holding the underlying stock in the covered call strategy, the alternative.... [Read on...]
Some stocks pay generous dividends every quarter. You qualify for the dividend if
you are holding on the shares before the ex-dividend date.... [Read on...]
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companies you wish to buy, it is often necessary to
take on higher risk. A most common way to do that is to buy stocks on margin.... [Read on...]
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Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator.... [Read on...]
Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa.... [Read on...]
In options trading, you may notice the use of certain greek alphabets like delta
or gamma when describing risks associated with various positions. They are known as "the greeks".... [Read on...]
Since the value of stock options depends on the price of the underlying stock, it
is useful to calculate the fair value of the stock by using a technique known as
discounted cash flow....
[Read on...]
Risk Warning: Stocks, futures and binary options trading discussed on this website can be considered High-Risk Trading Operations and their execution can be very risky and may result in significant losses or even in a total loss of all funds on your account. You should not risk more than you afford to lose. Before deciding to trade, you need to ensure that you understand the risks involved taking into account your investment objectives and level of experience.
Information on this website is provided strictly for informational and educational purposes only and is not intended as a trading recommendation service. TheOptionsGuide.com shall not be liable for any errors, omissions, or delays in the content, or for any actions taken in reliance thereon.
Buy 1 ITM Call Sell 2 ATM Calls Buy 1 OTM Call
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Butterfly (options) - Wikipedia
Butterfly Spread Explained | Online Option Trading Guide
Long Call Butterfly Spread | Butterfly Spreads - The Options Playbook
Everything You Need to Know About Butterfly Spreads
Butterfly Spread Strategy - The Basics - Trading Blog - SteadyOptions
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The Options Strategies » Long Butterfly Spread w/Calls
A long call butterfly spread is a combination of a long call spread and a short call spread , with the spreads converging at strike price B.
Ideally, you want the calls with strikes B and C to expire worthless while capturing the intrinsic value of the in-the-money call with strike A.
Because you’re selling the two options with strike B, butterflies are a relatively low-cost strategy. So the risk vs. reward can be tempting. However, the odds of hitting the sweet spot are fairly low.
Constructing your butterfly spread with strike B slightly in-the-money or slightly out-of-the-money may make it a bit less expensive to run. This will put a directional bias on the trade. If strike B is higher than the stock price, this would be considered a bullish trade. If strike B is below the stock price, it would be a bearish trade. (But for simplicity’s sake, if bearish, puts would usually be used to construct the spread.)
Some investors may wish to run this strategy using index options rather than options on individual stocks. That’s because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index’s component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.
NOTE: Strike prices are equidistant, and all options have the same expiration month.
NOTE: Due to the narrow sweet spot and the fact you’re trading three different options in one strategy, butterfly spreads may be better suited for more advanced option traders.
Typically, investors will use butterfly spreads when anticipating minimal movement on the stock within a specific time frame.
There are two break-even points for this play:
You want the stock price to be exactly at strike B at expiration.
Potential profit is limited to strike B minus strike A minus the net debit paid.
Risk is limited to the net debit paid.
After the trade is paid for, no additional margin is required.
For this strategy, time decay is your friend. Ideally, you want all options except the call with strike A to expire worthless with the stock precisely at strike B.
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast was correct and the stock price is at or around strike B, you want volatility to decrease. Your main concern is the two options you sold at strike B. A decrease in implied volatility will cause those near-the-money options to decrease in value, thereby increasing the overall value of the butterfly. In addition, you want the stock price to remain stable around strike B, and a decrease in implied volatility suggests that may be the case.
If your forecast was incorrect and the stock price is approaching or outside of strike A or C, in general you want volatility to increase, especially as expiration approaches. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike B, thereby increasing the overall value of the butterfly.
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