Butterfly Spread is a neutral strategy that combines the advantages of both bull and bear spreads. It’s a strategy with restricted profit potential and a limited risk profile. In finance, a butterfly is a non-directional options strategy with a high probability of earning a little profit when the underlying asset’s future volatility is expected to be lower or higher than the asset’s current implied volatility.
As an options strategy, it incorporates bull as well as bear spreads. These spreads come with a fixed risk along with capped profits and losses. It will let you pay off in case the underlying assets do not move before the expiration of the option. It comprises four options along with three different strike prices. In this upper strike price and lower strike price will be at an equal distance from the middle strike price.
What is Butterfly Spread?
Definition: A butterfly spread is defined as the options strategy responsible for combining bull and bear spreads with defined risk and profit cap. These spreads are designed to be a market-neutral strategy that pays out the most if the underlying asset does not move before the option expires.
3 striking prices are associated with butterfly spreads and they can be constructed with the help of calls or puts. Four calls, four puts, or a mix of puts and calls with three strike prices are used. Options trading is done by using butterfly spreads by options traders.
Here you should understand that an option is a financial instrument that depends upon the value of an underlying asset like a commodity or a stock. Options contracts let buyers go for buying or selling the underlying asset by an exercise or expiration date.
Characteristics of Butterfly Spreads
As a neutral strategy, butterfly spread uses four options contracts with the same expiration along with three different strike prices, and they are- a higher strike price, an at-the-money strike price, and a lower strike price.
The options that have higher and lower strike prices will be at the same distance from the at-the-money options.
Understanding Butterfly Spreads
Options traders employ butterfly spreads as a strategy. Keep in mind that an option is a financial instrument whose value is determined by the value of an underlying asset, such as a stock or commodity. Buyers of options contracts can purchase or sell the underlying asset before the expiration or exercise date.
A butterfly spread, as previously said, comprises both a bull and a bear spread; this is a neutral approach in which four options contracts with the same expiration date but three different strike prices are used:
- An increase in the strike price
- A special price that is exactly in the money
- A more affordable unique price
The at-the-money options are the same distance away as those with higher and lower strike prices. If the strike price of the at-the-money options is $60, the strike prices of the higher and lower options should be equal dollar amounts above and below $60.
Types of Butterfly Spreads
1. Butterfly Spread “Long Call”
Purchasing 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 creates the long butterfly call spread. When you enter a trade, you make net debt.
If the underlying price at expiry is the same as the written calls, the maximum profit is attained. The maximum profit is determined by subtracting the written option’s strike from the lower call’s strike, premiums, and commissions paid; the maximum loss is equal to the amount paid in bonuses plus commissions.
2. Butterfly Spread with a Short Call
Selling one in-the-money call option with a lower strike price, purchasing two at-the-money call options, and selling one out-of-the-money call option with a higher strike price makes up the short butterfly spread. When you take the job, you get a net credit. If the underlying price is above or below the upper strike or below the lower strike at expiry, this position maximizes profit.
The maximum profit equals the first premium collected with fewer commission costs. The maximum loss equals the difference between the purchased call’s strike price, and the lower the strike price, the less the premiums earned.
3. Butterfly Spread with Long Put
Buying one put with a lower strike price, selling two at-the-money puts, and buying a put with a higher strike price creates the long put butterfly spread.
When you take a position, you create net debt. Like the long call butterfly, this position makes the most money when the underlying stays at the strike price of the middle options.
4. Butterfly Spread Short Put
Writing one out-of-the-money put option with a low strike price, purchasing two at-the-money puts, and registering one in-the-money put option with a higher strike price results in the short put butterfly spread.
This method makes the most money if the underlying price is above the upper strike or below the lower strike price at expiration.
5. Iron Butterfly Spread
Purchasing 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 makes up the iron butterfly spread.
As a consequence, you’ll have a transaction with a net credit that’s better for lower-volatility circumstances.
6. Butterfly Spread in Reverse Iron
Writing an out-of-the-money put at a lower strike price, purchasing an at-the-money put, buying an at-the-money call, and writing an out-of-the-money call at a higher strike price from the reverse iron butterfly spread.
This results in a net negative trade that works best in high-volatility situations. The maximum profit is realized when the cost of the underlying moves above or below the higher or lower strike prices.
Example of Butterfly Spread
Let’s imagine the stock of ABC is trading at $60. According to one investor, it is not expected to move considerably in the next months. They decide to use a long call butterfly spread in order to benefit if the price stays the same. The investor buys two more calls at $55 and $65 and writes two call options on Verizon with a strike price of $60.
If Verizon stock is priced at $60 at expiration, the investor makes the most money in this scenario. If Verizon closes below $55 or above $65, the investor suffers the maximum loss, equal to the cost of purchasing the two wing call options less the profits.
How Is a Long Call Butterfly Spread Constructed?
The long call butterfly spread can be constructed by buying a one-in-the-money call option that has a low strike price, buying one out-of-the-money call option with a higher strike price, and writing or selling two at-the-money call options. Net debt will be created at the time when you enter the trade.
For accomplishing optimum profit, it is important that the price of the underlying asset at expiration is similar to the written calls. Optimum profit will be equal to the strike of the written option by blessing the strike of the lower call, commissions paid, and premiums. The optimum loss here will be the initial cost of the premiums paid including commissions.
Conclusion!
The higher strike price minus the strike of the sold put, less the premium paid, equals the maximum profit. The trade’s maximum loss is restricted to the tips and fees paid at the start.
In today’s market, where the market has become highly volatile with significant intraday swings, a trader can’t hold a two-leg strategy like a Bull Call Spread or Bear Put Spread, where losses and gains are restricted. Still, it often doesn’t seem worth the risk. The butterfly is one method that still appeals to me.
In the world of finance, butterfly spreads are understood as a limited risk and non-directional options strategy made for having a high probability of earning a limited profit at the time when future volatilities of some underlying assets are supposed to be lower in the case of the long butterfly or higher in the cases of short butterfly than the current implied volatility of the assets.
