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.
|Butterfly Spread Construction|
|Buy 1 ITM Call|
Sell 2 ATM Calls
Buy 1 OTM Call
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.
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.
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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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