Home Money & Finance The Butterfly Spread Option Strategy

The Butterfly Spread Option Strategy

by Olufisayo
Butterfly Spread Option

The butterfly spread is an options trading strategy that involves both bull and bear spreads. The risk is fixed, but there is also an upper limit for the possible profit. To put it simply: before you invest, you will already know the maximum possible loss and the maximum possible profit.

This strategy involves both buying and writing options

The butterfly spread option strategy is an advanced options trading strategy that involves both buying and writing options. It is not recommended for beginners.

Four options per butterfly

A butterfly spread will always be comprised of four options, and all four options have the same expiry date. It can be four call options, four put options, or a combination of calls and puts.

Three strike prices

A  butterfly spread strategy always uses options with three (not four) different strike prices.

  • The higher strike price
  • The at-the-money strike price (middle strike price)
  • The lower strike price

The upper and lower strike prices will be at an equal distance from the middle strike price.

       

Example: The middle strike price is 60 USD, the higher strike price is 70 USD and the lower strike price is 50 USD. 70 and 50 are each ten steps away from 60.

When is the butterfly spread good?

The butterfly spread is typically employed when a trader has reason to believe that the price of the underlying will not move (or will not move by much) before the options expire. It is thus a strategy developed to help you profit from stagnant markets.

What is a long call butterfly spread?

The long call butterfly spread involves this:

  • Buy one call option that has a low strike price and is in-the-money
  • Write two at-the-money call options
  • Buy one call option that has a high strike price and is out-of-the-money

Important: Net debt is created from these actions.

When is did strategy good? The long call butterfly spread reaches its maximum profit level if the price of the underlying (at expiration) is the same as the two options you wrote.

       

What is a short call butterfly spread?

You make a short call butterfly spread by following these steps:

  • Write one in-the-money call option with a low strike price
  • Buy two at-the-money call options
  • Write one out-of-the-money call option with a high strike price

A net credit is created as you enter this position.

What is a long put butterfly spread?

How to make a long put butterfly spread:

  • Purchase one put option with a low strike price.
  • Write two at-the-money put options.
  • Purchase a put option with a high strike price.

As you enter this position, net debts are created.

What is a short put butterfly spread?

You create a short put butterfly spread by:

       
  • Writing one out-of-the-money put option with a low strike price.
  • Buying two at-the-money put options.
  • Writing an in-the-money put option with a high strike price.

The Iron Butterfly Spread

Do you want to make an Iron Butterfly Spread? Start by purchasing a put option that is out-of-the-money and has a low strike price. You then write two options: one is a put option that is at-the-money and the other one is a call option that is at-the-money. Finally, you purchase a call option that is out-of-the-money and has a high strike price. By doing this, you create a net credit.

The iron butterfly spread is especially popular among traders who are trying to profit on a market characterized by low volatility. If the price of the underlying asset stays at the middle strike price level, maximum profit is achieved.

If you are dealing with a high-volatility situation, you can do the exact opposite and create a reversed iron butterfly spread. This solution reaches maximum profitability if the price of the underlying asset goes above the higher strike price or below the lower strike price.

You make a reversed iron butterfly by writing an out-of-the-money put option with a low strike price, purchasing an at-the-money put options, purchasing an at-the-money call option, and finally writing an out-of-the-money call option with a high strike price. As you enter this position, you are creating a net debit. o

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