The butterfly spread is an advanced options strategy that combines elements of both bull and bear spreads, using four options of the same type (calls or puts) with three different strike prices. This strategy is designed to have limited risk and a capped profit, making it a popular choice for traders looking to profit from low volatility in the underlying asset.
Types of Butterfly Spreads
Long Butterfly Spread with Calls
Involves purchasing one call option at a lower strike price, selling two call options at a middle strike price, and buying one call option at a higher strike price. This strategy profits when the underlying asset’s price is near the middle strike price at expiration.
Long Butterfly Spread with Puts
Similar to the call strategy, but uses put options. Here, a trader buys a put option at a higher strike price, sells two put options at a middle strike price, and buys another put option at a lower strike price.
Iron Butterfly Spread
Involves both calls and puts. A trader sells a call and a put option at the same middle strike price while buying another call at a higher strike price and another put at a lower strike price. The iron butterfly has a different margin requirement due to its combination of spreads.
Setting Up a Butterfly Spread
Selecting Strike Prices
The selection of strike prices is crucial to the success of a butterfly spread strategy. The middle strike price is usually chosen based on the expected price of the underlying asset at expiration.
Determining Expiration Dates
Choose expiration dates based on your market outlook. A shorter time frame might be preferable if you expect the market to stay flat soon, while a longer time frame could be better for extended periods of low volatility.
Example Calculation
Let’s assume a stock is currently trading at $100:
- Buy one lower strike call at $95
- Sell two middle strike calls at $100
- Buy one higher strike call at $105
The maximum profit occurs if the stock price is exactly $100 at expiration, where the lower strike call gains value, the middle strike calls expire worthless, and the higher strike call is also out of the money.
Risks and Considerations
- Limited Risk: The maximum loss is limited to the net premium paid for the butterfly spread.
- Capped Profit: The potential gain is also limited and is achieved if the underlying asset’s price is exactly at the middle strike price at expiration.
- Commissions and Fees: Due to the number of options contracts involved, transaction costs can be substantial.
Comparison with Other Strategies
- Compared to Straddles: Butterfly spreads typically cost less and profits are confined to a narrower range of underlying asset prices.
- Compared to Iron Condors: Both use four options, but iron condors involve selling out-of-the-money spreads, preferable for higher volatility expectations.
Related Terms
- Bull Spread: Options strategy aiming to profit from a moderate rise in the underlying asset’s price.
- Bear Spread: Strategy designed to profit from a moderate decline in the underlying asset’s price.
FAQs
What is the breakeven point for a butterfly spread?
Can I use butterfly spreads in a high-volatility market?
What underlies the butterfly's limited risk?
References
- Hull, J.C. “Options, Futures, and Other Derivatives”
- McMillan, L.G. “Options as a Strategic Investment”
Summary
The butterfly spread is a sophisticated options trading strategy perfect for experienced traders expecting low volatility. With fixed risk and capped profit, it appeals to those seeking controlled exposure in their trading activities. Traders should carefully consider strike prices, expiration dates, and associated costs before utilizing this strategy.
