Butterfly Spread

Butterfly Spread
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Evan is a Senior Technology Analyst at The Motley Fool. He was previously a Senior Trading Specialist at Charles Schwab, and worked briefly at Tesla. Evan graduated from the University of Texas at Austin, and is a CFA charterholder.

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There are plenty of ways to profit on a stock's movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.
A call is an options contract that gives the owner the right to purchase the underlying security at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.
A butterfly spread is a neutral strategy where the trader does not think the stock will move very much. Here's how it works.
A butterfly is a combination of a bull spread and a bear spread that have an overlapping middle strike price. The strategy consists of buying an out-of-the-money (OTM) call above the current stock price, buying an in-the-money (ITM) call below the current stock price, and selling two at-the-money (ATM) calls near the current stock price. You can also use all puts if you choose.
A related variant of the butterfly spread is the iron butterfly , which uses a combination of calls and puts instead of just calls or just puts. The butterfly and the iron butterfly are strategically similar.
For example, if a stock was trading at $50 and you wanted to establish a butterfly, you could buy a $45 call, sell two $50 calls, and buy a $55 call. Let's say the $45 call is trading at $7, the $50 call is trading at $3, and the $55 call is trading at $1. The net debit for this trade would be $2.
A butterfly has limited profit potential. The most that you can make on a butterfly is the difference between the middle and lower strike prices minus the net debit. If the stock stays flat, which is the goal of this strategy, the bullish call spread will realize its own maximum gain, while the bearish call spread expires worthless (but it helped offset the cost of the trade by bringing in premiums). The maximum gain is realized if the stock closes upon expiration at exactly the middle strike price.
In this example, if the stock closed at $50 upon expiration, the bullish call spread would be exercised. You would purchase the stock at $45, then sell it at $50 for a $5 gain. The remaining $50 call would expire worthless, as would the $55 call. Then you would subtract out the net debit of $2 paid in premium for a total gain of $3.
Butterfly spreads also have limited risk. The most that you can lose on a butterfly is the net premium paid. This occurs if the stock does not stay flat and increases or decreases beyond the upper or lower strike prices. The maximum loss is realized if the stock closes upon expiration below the lower strike or above the upper strike.
In this example, if the stock closed below $45, then all call contracts would expire worthless and you would lose the $2 in net debit. Conversely, if the stock closed above $55, then the bullish call spread would realize its maximum gain of $5 (buy at $45, sell at $50), but then bearish call spread would simultaneously realize its maximum loss of $5 (buy at $55, sell at $50) to exactly offset that gain, while you still lose the $2 in net debit.
Butterfly spreads have two breakeven points since there are two spreads involved. The breakeven points are the higher strike price minus the net debit, or the lower strike plus the net debit.
In this example, if the stock closed at $47 (lower strike plus net debit), then the bullish call spread would have a value of $2, which exactly offsets the $2 net debit, while the bearish call spread expires worthless. If the stock closed at $53 (higher strike minus net debit), the bullish call spread would be worth $5, the bearish call spread would lose $3, and you subtract out the $2 net debit to break even.
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Butterfly spreads are one of the most popular trades among professional traders, second only to Iron Condors .
The are amazingly versatile and unlike Condors, they have a favorable risk/reward ratio.
You’re going to learn more today about Butterflies than you thought possible, so grab a coffee and strap in.
A butterfly is a neutral (generally), income-oriented strategy. It is a limited risk and limited profit trade, but on a typical butterfly trade, the profit potential is higher than the potential loss.
Butterfly spreads involve 3 different option strike prices, all within the same expiration date, and can be created using either calls or puts. A typical butterfly would be constructed as follows:
Buy 1 in-the-money call
Sell 2 at-the-money calls
Buy 1 out-of-the-money call
The in-the-money and out-of-the-money calls are placed at an equal distance from the short strike. A butterfly trade is entered for a net debit which means money will be deducted from your account once the trade is placed.
This is the maximum amount that you can lose from the trade. The maximum profit is calculated as the difference between the short and long calls less the premium that you paid for the spread.
For example if you had the following butterfly spread:
Long 1 June $95 call @ $5.00
Short 2 June $100 calls @ $2.50
Long 1 June $105 call @ $1.00
The total net debit to enter this trade is $1, which means the maximum profit is $4. This is calculated as the difference in the strike prices from the short to long strikes ($5) less the premium paid ($1).
The potential return on investment is 400% and this would occur if the stock closed exactly at $100 at expiration. You should be aware the achieving the full 400% return is extremely unlikely, but more on that later.
The breakeven points for a butterfly are calculated as follows:
Downside breakeven = lower call PLUS premium paid ($95 + $1) = $96
Upside breakeven = higher call LESS premium paid ($105 – $1) = $104
In this example, the maximum loss will be incurred if the stock closes at $96 or below and at $104 or above. You can see this on the diagram below.
As you can see above the butterfly payoff diagram, or expiration graph, has a tent-like shape with the potential for very large profits around the short strike. It’s important to keep in mind that it’s unlikely you would ever achieve the maximum profit.
In fact, some traders say that you should basically ignore the top one-third of the butterfly expiration graph, as it unlikely and unrealistic that your trade will finish in that area.
The other problem with the top third of the butterfly graph is that profits will fluctuate wildly, even with only small movements in the underlying due to the high level of short gamma.
The closer you get to expiry, the higher the gamma will become, and the more your profits will fluctuate.
A good aim for a butterfly trade is to make a 15-20% return on capital at risk.
Butterflies can be traded with either calls or puts, it doesn’t really matter. You can also trade an iron butterfly, which uses BOTH calls and puts. An iron butterfly is basically a combination of a bear call spread and a bull puts spread.
Generally speaking, traders will use calls for neutral and bullish butterflies and puts for bearish butterflies but there is no real hard and fast rule. Iron condor traders may prefer to trade iron butterflies.
Advanced traders might look at the relative skews of calls to puts.
If puts are much more expensive due to significantly higher levels of implied volatility, they may prefer to use puts, but generally speaking the payoff is going to be very similar whether you use calls, puts or both.
Unlike other options strategies such as iron condors and credit spreads, butterflies are very dynamic and can be traded for a variety of different reasons with different goals in mind. Some reasons to trade butterflies include:
Income – Butterflies are a great way to generate income from stocks you think are going nowhere in the short term. This can contribute to overall portfolio returns in flat markets.
Non-Directional – In their simplest form, butterflies are delta neutral or non-directional trades. Trying to pick the direction of stocks or the overall market can be stressful and expensive.
Delta neutral butterflies can be set up with strict rules to take the guesswork out of trading.
Hedging – Market makers and advanced traders often use directional butterflies as a short term hedge on positions that are moving against them.
Centering the profit tent of a butterfly around a strike that is under pressure in another trade (such as a credit spread) can be a great way to control risk and allow you to keep the original position open for a few more days.
Sometimes that is all you need for a trade to move back in your favor.
At that point you can then remove the butterfly hedge and stick with your original trade. Long-term out-of-the-money put butterflies can also be a much cheaper method of portfolio protection than pure long puts.
Low Maintenance – Butterflies are sometimes called “vacation trades” due to their low risk and need for only very infrequent monitoring. Butterfly trades are generally very slow moving early on in the trade.
They can get a little exciting and volatile when you get closer to expiry and are within the profit tent though.
Butterflies are a commission intensive strategy as you are trading 4 contracts each time you enter a trade, and 4 contracts when you exit a trade.
As most brokers charge transactions fees on a per contract basis, this can soon add up and should be taken into account when evaluating whether butterfly spreads are right for you.
The greeks will be discussed in detail shortly, but basically butterflies are short volatility, short gamma and long theta.
Gamma is a very important aspect to be aware of when trading butterflies, particularly as you get closer to expiry.
When trading multi-legged options strategies as one order, the bid-ask spreads can be significant and therefore make it difficult to initiate a trade for a decent price.
If you choose to enter the 3 legs individually, you run the risk of the market moving against you before having the entire position opened.
You can move the center strike of a butterfly slightly in-the-money or out-of-the-money to reduce the cost, however this gives the trade a directional bias.
Sometimes this can be a good thing and we will discuss directional butterflies in detail shortly.
The easiest way for beginners to enter a butterfly is to create a single order in your broker’s option trader module.
However, butterflies can be tricky to get filled on when entered as one order. In addition, the bid-ask spreads can be quite wide depending on the underlying stock that you are trading. You can see below, 3 separate butterfly spreads.
SPY being the most liquid of the 3, has the tightest of the 3 spreads with only $0.08 between the bid and the ask. AAPL is has a slightly higher spread on both a dollar and percentage basis with a spread of $0.69.
RUT is the least liquid of all with a massive difference between the bid and ask prices, on both a percentage and dollar basis.
The dollar spread of $1.70 is very high; you might be able to get filled close to the mid-point, but you run the risk of some slippage here if you are looking to trade butterflies on RUT. Definitely something to keep in mind.
If you’re having trouble getting filled on your single butterfly order, or you don’t like the look of those bid-ask spreads, another way to enter your butterfly is as a debit spread and a credit spread.
After all, that’s all a butterfly is – a combination of a debit spread and credit spread.
Looking at our AAPL example, you would buy 1 AAPL June 21 $425 – $450 debit call spread and sell 1 AAPL June 21 $450 – $475 credit call spread.
You’re looking at a bid-ask spread of $0.40 on the debit spread and $0.16 on the credit spread.
The total spread is less than our butterfly trade ($0.56 v $0.69). You will also find it easier to get filled on two vertical spreads rather than one butterfly spread.
The SPY spreads are fairly similar which makes sense given the huge levels of liquidity. Trading the two vertical spreads has a total bid-ask spread of $0.09 compared to the single butterfly order at $0.08.
The bid-ask spread on RUT is similar to AAPL in that it is slightly lower when entering at two vertical spreads – $1.50 v $1.70. So for RUT you will find it easier getting filled using the two vertical spread method.
When starting out with butterfly trades, it is prudent to start trading highly liquid stocks and ETF’s. SPY is one of the most liquid instruments in the world, so this would be a good place to start for your butterfly trades.
Try entering your trades via the two methods presented above and see which method is easier to get filled.
Once you become familiar and confident with entering the trades and getting filled, you can then move on to trading other instruments and trading different variations of the butterfly which we will discuss shortly.
When trading butterflies it is easy to get caught up in the hope (a very dangerous word in the stock market) of achieving the full profit as shown in the payoff diagram.
As mentioned previously, it is extremely unlikely that you will achieve the full profit potential on a butterfly trade. A good aim for a butterfly trade is a 15-20% return on capital at risk and the maximum acceptable loss should also be around the 15-20% level.
As with most income strategies, you need to make sure when you have a losing trade, you are not losing much more than the typical gain you are making from your winning trades.
Typically you should set a hard stop loss at 1.5 times the average gain. So if you are generally making 15% on your butterflies, your maximum loss on any trade should be around 20-25%.
When taking profits, you can also set time-based rules for taking profits. For example, if you have made 10% within 10 days of opening a 35 day trade, that might be a really good place to take profits even though your initial target was 15%.
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