What is butterfly trading strategy?

investopedia.com - Butterfly Spread: What It Is, With Types Explained & Example - Investopedia

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What Is a Butterfly Spread?

The term butterfly spread refers to an options strategy that combines bull and bear spreads with a fixed risk and capped profit. These spreads are intended as a market-neutral strategy and pay off the most if the underlying asset does not move prior to option expiration. They involve either four calls, four puts, or a combination of puts and calls with three strike prices. Key Takeaways A butterfly spread is an options strategy that combines both bull and bear spreads. These are neutral strategies that come with a fixed risk and capped profits and losses. Butterfly spreads pay off the most if the underlying asset doesn't move before the option expires.

These spreads use four options and three different strike prices.

The upper and lower strike prices are equal distance from the middle, or at-the-money, strike price.

Understanding Butterfly Spreads

Butterfly spreads are strategies used by options traders. Remember that an option is a financial instrument that is based on the value of an underlying asset, such as a stock or a commodity. Options contracts allow buyers to buy or sell the underlying asset by a specific expiration or exercise date. As noted above, a butterfly spread combines both a bull and bear spread. This is a neutral strategy that uses four options contracts with the same expiration but three different strike prices:

A higher strike price

An at-the-money strike price

A lower strike price

The options with the higher and lower strike prices are the same distance from the at-the-money options. If the at-the-money options have a strike price of $60, the upper and lower options should have strike prices equal dollar amounts above and below $60. At $55 and $65, for example, as these strikes are both $5 away from $60. Puts or calls can be used for a butterfly spread. Combining the options in various ways will create different types of butterfly spreads, each designed to either profit from volatility or low volatility. A spread strategy can be characterized by its payoff or the visualizations of its profit-loss profile.

Types of Butterfly Spreads

Long Call Butterfly Spread

The long butterfly call spread is created by buying one in-the-money call option with a low strike price, writing two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. Net debt is created when entering the trade. The maximum profit is achieved if the price of the underlying at expiration is the same as the written calls. The max profit is equal to the strike of the written option, less the strike of the lower call, premiums, and commissions paid. The maximum loss is the initial cost of the premiums paid, plus commissions.

Short Call Butterfly Spread

The short butterfly spread is created by selling one in-the-money call option with a lower strike price, buying two at-the-money call options, and selling an out-of-the-money call option at a higher strike price. A net credit is created when entering the position. This position maximizes its profit if the price of the underlying is above or the upper strike or below the lower strike at expiry.

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The maximum profit is equal to the initial premium received, less the price of commissions. The maximum loss is the strike price of the bought call minus the lower strike price, less the premiums received.

Long Put Butterfly Spread

The long put butterfly spread is created by buying one put with a lower strike price, selling two at-the-money puts, and buying a put with a higher strike price. Net debt is created when entering the position. Like the long call butterfly, this position has a maximum profit when the underlying stays at the strike price of the middle options. The maximum profit is equal to the higher strike price minus the strike of the sold put, less the premium paid. The maximum loss of the trade is limited to the initial premiums and commissions paid.

Short Put Butterfly Spread

The short put butterfly spread is created by writing one out-of-the-money put option with a low strike price, buying two at-the-money puts, and writing an in-the-money put option at a higher strike price. This strategy realizes its maximum profit if the price of the underlying is above the upper strike or below the lower strike price at expiration. The maximum profit for the strategy is the premiums received. The maximum loss is the higher strike price minus the strike of the bought put, less the premiums received.

Iron Butterfly Spread

The iron butterfly spread is created by buying an out-of-the-money put option with a lower strike price, writing an at-the-money put option, writing an at-the-money call option, and buying an out-of-the-money call option with a higher strike price. The result is a trade with a net credit that's best suited for lower volatility scenarios. The maximum profit occurs if the underlying stays at the middle strike price. The maximum profit is the premiums received. The maximum loss is the strike price of the bought call minus the strike price of the written call, less the premiums received.

Reverse Iron Butterfly Spread

The reverse iron butterfly spread is created by writing an out-of-the-money put at a lower strike price, buying an at-the-money put, buying an at-the-money call, and writing an out-of-the-money call at a higher strike price. This creates a net debit trade that's best suited for high-volatility scenarios. Maximum profit occurs when the price of the underlying moves above or below the upper or lower strike prices. The strategy's risk is limited to the premium paid to attain the position. The maximum profit is the strike price of the written call minus the strike of the bought call, less the premiums paid.

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Example of a Long Call Butterfly Spread

Let's say Verizon (VZ) stock trades at $60. An investor believes it will not move significantly over the next several months. They choose to implement a long call butterfly spread to potentially profit if the price stays where it is. The investor writes two call options on Verizon at a strike price of $60, and also buys two additional calls at $55 and $65. In this scenario, the investor makes the maximum profit if Verizon stock is priced at $60 at expiration. If Verizon is below $55 at expiration, or above $65, the investor realizes their maximum loss, which is the cost of buying the two wing call options (the higher and lower strike) reduced by the proceeds of selling the two middle strike options. If the underlying asset is priced between $55 and $65, a loss or profit may occur. But the premium paid to enter the position is key. Assume that it costs $2.50 to enter the position. Based on that, if Verizon is priced anywhere below $60 minus $2.50, the position would experience a loss. The same holds true if the underlying asset is priced at $60 plus $2.50 at expiration. In this scenario, the position profits if the underlying asset's price falls between $57.50 and $62.50 at expiration. This scenario does not include the cost of commissions, which can add up when trading multiple options. What Are the Characteristics of a Butterfly Spread? Butterfly spreads use four option contracts with the same expiration but three different strike prices. A higher strike price, an at-the-money strike price, and a lower strike price. The options with the higher and lower strike prices are the same distance from the at-the-money options. Each type of butterfly has a maximum profit and a maximum loss. How Is a Long Call Butterfly Spread Constructed? The long call butterfly spread is created by buying a one in-the-money call option with a low strike price, writing (selling) two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. Net debt is created when you enter the trade. The maximum profit is achieved if the price of the underlying asset at expiration is the same as the written calls. The max profit is equal to the strike of the written option, less the strike of the lower call, premiums, and commissions paid. The maximum loss is the initial cost of the premiums paid, plus commissions.

investopedia.com - Butterfly Spread: What It Is, With Types Explained & Example - Investopedia

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