What is Butterfly Spread Options?
The Butterfly Spread is an options trading strategy that combines elements of both bull and bear spreads, offering a strategy with limited profit and limited risk. This approach is ideal for traders seeking a balanced compromise between profit potential and risk exposure.
This strategy involves using various call or put options on the same underlying asset, all expiring at the same time but with differing strike prices. It requires three distinct strike prices to execute four separate trades. Traders can opt for four butterfly call options, four butterfly put options, or a mix of both.
The butterfly spread options strategy provides a neutral pathway to potentially profit from options trading. It involves initiating a call or put option and then layering additional calls or puts as a safeguard against unexpected stock movements. The strategy gets its name from its graphical representation, which mimics the shape of a butterfly.
The structure of this strategy includes one call/put at a lower strike price, two calls/puts at a middle strike price, and one call/put at a higher strike price. All these options are based on the same underlying asset and have the same expiration date. The higher and lower strike prices are equidistant from the middle strike price.
For example, an investor employing this strategy might buy a call at 2285, sell two 2310 calls, and buy a 2335 call on the same security, all expiring on the same date. When plotted on a graph, this arrangement forms a butterfly shape, where the 2285 and 2335 positions represent the wings, and the 2310 position forms the body.
Butterfly spread options are most effective in markets that lack clear direction and exhibit low volatility. In such markets, the underlying asset's price aligning with the middle strike price at expiration maximizes the strategy’s effectiveness.
Thus, this strategy is advantageous for investors who anticipate stagnant prices. Even if prices vary, the structure's "wings" can help limit losses. Consequently, the butterfly spread caps both potential profits and risks, enabling a more measured and cautious investment approach.
Types of Butterfly Spread Options
The butterfly spread options manifest in several variations:
#1 – Long call butterfly
This spread is initiated when investors anticipate that the underlying stock price will remain stable at expiration. In this strategy, traders execute the following:
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 options are based on the same underlying security and share the same expiration date. Maximum profit is realized if the security price matches the middle strike price at expiration.
#2 – Short call butterfly
In this version of the strategy, traders perform the following actions:
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
Maximum profit is achievable if the security price exceeds the higher strike price or falls below the lower strike price at expiration.
#3 – Long put butterfly
This spread is employed 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
The maximum profit occurs when the security price equals the middle strike price on the expiration date.
#4 – Short put butterfly
In the short put butterfly, 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 achieve maximum profit when the security price is above the higher strike price or below the lower strike price at expiration.
#5 – Iron butterfly
This strategy involves a mix of call and put 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
Maximum profit is attained when the price of the underlying security equals the middle strike price at expiration.
#6 – Reverse iron butterfly
The reverse iron butterfly, a strategy with limited risk and profit potential, is used when sharp movements in the underlying securities are anticipated. It includes:
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 is achieved when the security price is between the higher and lower strike prices at expiration.
Various Butterfly Options Strategy
Traders often start with the basic butterfly and progressively incorporate more complex strategies. The objective is to master additional strategies after becoming proficient with the basic butterfly options spread.
Here are some notable strategies:
- Butterfly Options Strategy: Employs three different option strike prices within the same expiration date, using either calls or puts. A typical butterfly involves buying an in-the-money call, selling two at-the-money calls, and buying an out-of-the-money call. The maximum and minimum strike prices are equidistant from the middle strike price. This strategy uses four options contracts to create a profitable range.
- Iron Butterfly Options Strategy: Ideal for lower volatility markets, it consists of four options trades. This setup involves buying an out-of-the-money put option and a call option at different strike prices, and writing an at-the-money put and call option. Maximum profit occurs if the underlying price remains at the middle strike price.
- Reverse Iron Butterfly Options Strategy: Suited for high-volatility markets, it is formed by writing an out-of-the-money put and call at lower and higher strike prices, respectively, and buying an at-the-money put and call. Maximum profit occurs when the underlying price moves significantly above or below the strike prices.
- Broken Wing Butterfly Options Strategy: An advanced spread with asymmetrical risk. It shifts all the risk to one direction, offering higher profits if the stock moves as expected, but increased risk for maximum loss if it doesn't.
- Long Call Butterfly Options Strategy: Involves buying an in-the-money call option with a low strike price, writing two at-the-money call options, and buying an out-of-the-money call option with a higher strike price. Maximum profit is made if the underlying price at expiration equals the at-the-money calls’ strike price.
- Long Put Butterfly Options Strategy: Similar to the long call butterfly, but using puts. It consists of buying a put with a lower strike price, selling two at-the-money puts, and buying a higher strike price put. Maximum profit is achieved when the underlying price remains at the middle options' strike price.
- Double Iron Butterfly Options Strategy: A combination of two Iron Butterfly spreads, targeting profitability around two different price points. This strategy is market neutral and aims for a favorable risk-to-reward ratio with higher potential gains.
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