Butterfly Spread
The butterfly spread represents an advanced options trading strategy that encompasses three transactions. Typically, it is structured using calls, known as a call butterfly spread, although it can utilize puts to form a put butterfly spread, offering similar potential pay-offs.
This strategy is classified as neutral as it aims to capitalize on securities with minimal price fluctuations. The profit and loss potential are both capped, requiring an initial investment to establish the spread. For comprehensive details on this strategy, please refer below.
Main Points
Neutral Strategy
Not Recommended for Novices
Three Transactions (buy calls /write calls /buy calls)
Puts can also be utilized
Debit Spread (upfront cost)
Intermediate/Advanced Trading Proficiency Required
When to Employ a Butterfly Spread
The butterfly spread is most effective when anticipating minimal or no movement in a security's price. It thrives when the price remains stagnant, incurring losses if the security's value shifts significantly in either direction.
Unlike some neutral strategies, losses are contained, making it a viable option when predicting stability in a security's price while acknowledging the potential for substantial movements. This intricate strategy is better suited for seasoned traders due to its complexity and the requisite higher trading expertise.
Creating a Butterfly Spread Strategy
In order to set up this spread, your broker needs to execute three orders. These orders can be placed all at once or sequentially to maximize profits and/or lower initial expenses. Although the strategy can involve calls or puts, this guide specifically emphasizes calls. The following transactions are crucial:
Purchase in-the-money calls.
Acquire an equivalent number of out-of-the-money calls.
Write twice the number of at-the-money calls.
It is recommended that all contracts have the same expiration date, whether short or long term. Choosing a near-term expiration is preferable as it reduces the time for the underlying security to fluctuate.
When it comes to strike prices, the in-the-money and out-of-the-money contracts should have strikes that are equally distant from the security's current trading price. The selection of strike prices affects the strategy in two ways.
Opting for strikes close to the current trading price narrows the profit range. Choosing strikes further from the current price widens the profit range but also increases the initial cost.
Here is a hypothetical example demonstrating how to set up a butterfly spread. Please be aware that this example does not involve actual market data or include commission fees. Its purpose is to illustrate the mechanics of the strategy.
Potential for Profit and Loss
Maximum returns are attained when the price of the underlying security remains constant at expiration, matching the strike price of the options in Leg C. In this situation, options in Legs B and C expire without value, whereas those in Leg A generate profit, resulting in a satisfactory return on the initial investment.
In addition, the strategy results in a profit when the security's price stays within certain boundaries. The break-even points are calculated and explained in more detail below.
A loss is incurred if the security's price deviates significantly. A considerable drop makes all options worthless, causing a complete loss of the initial investment. On the other hand, a substantial rise increases the value of owned calls but also raises the value of written calls, balancing each other out and resulting in a loss equal to the initial expenditure.
Below, various outcome scenarios, profit calculations, and break-even points are outlined.
If Company Y stock remains at $150 at expiration, Leg A options would be valued around $3 each ($300 total), while Legs B and C options would expire worthless. After deducting the $50 initial investment, a $250 profit is realized.
In the event of Company Y stock rising to $155 at expiration, Leg A options would be valued around $8 each ($800 total), Leg B options around $2 each ($200 total), and Leg C options around $5 each ($1,000 total liability). The owned options offset the liability, resulting in a $50 loss, equivalent to the initial investment.
If Company X stock falls to $45 at expiration, all options in Legs A, B, and C expire worthless, leading to a $50 loss.
Maximum profit occurs when "Price of Underlying Stock = Strike in Leg C."
Maximum profit is calculated as "((Strike of Options in Leg C – Strike of Options in Leg A) x Number of Options in Leg A) – Initial Cost."
Two break-even points are identified (Upper Break-Even Point and Lower Break-Even Point).
Upper Break-Even Point = "Strike of Leg B - (Net Debit/Number of Options in Leg A)."
Lower Break-Even Point = "Strike of Leg A + (Net Debit/Number of Options in Leg A)."
A profit is realized if "Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point."
A loss is incurred if "Price of Underlying Security > Upper Break-Even Point or < Lower Break-Even Point."
You have the option to close the position before expiration if it is profitable and you wish to secure the gains.
Different Versions of the Butterfly Spread
Two types of butterfly spreads have been discussed: the call butterfly spread, which uses calls as shown, and the put butterfly spread, which is structured similarly but uses puts instead of calls.
A different type of spread is the broken wing butterfly spread, in which out-of-the-money options are purchased at a strike price that is farther from the current price of the security compared to the in-the-money options. This modification lowers the cost of the strategy and is sometimes called the skip strike butterfly spread.
Utilizing this strategy with calls (known as call broken wing butterfly spread) helps reduce or eliminate losses in case the security's price decreases, but can amplify losses if it goes up. On the other hand, employing puts (referred to as put broken wing butterfly spread) decreases or eliminates losses if the security's price goes up, but can lead to increased losses if it drops.
Overview
If the security stays stable or moves slightly, the butterfly spread has the potential to generate substantial profits. It comes with a set maximum profit and loss, which helps in planning trades. However, the main disadvantage is that it requires three transactions, which could lead to increased commission expenses.
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