Butterfly Spread Explained

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Butterfly Spread

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 Call Butterfly

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.

Limited Profit

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:

  • Max Profit = Strike Price of Short Call – Strike Price of Lower Strike Long Call – Net Premium Paid – Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Short Calls

Limited Risk

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:

  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying = Strike Price of Higher Strike Long Call

Breakeven Point(s)

There are 2 break-even points for the butterfly spread position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Strike Price of Higher Strike Long Call – Net Premium Paid
  • Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid

Example

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.

Note: While we have covered the use of this strategy with reference to stock options, the butterfly spread is equally applicable using ETF options, index options as well as options on futures.

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Commissions

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.

If you make multi-legged options trades frequently, you should check out the brokerage firm OptionsHouse.com where they charge a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

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.

Butterfly Spread

What Is a Butterfly Spread?

A butterfly spread is an options strategy combining bull and bear spreads, with a fixed risk and capped profit. These spreads, involving either four calls or four puts are intended as a market-neutral strategy and pay off the most if the underlying does not move prior to option expiration.

Key Takeaways

  • There are multiple butterfly spreads, all using four options.
  • All butterfly spreads use three different strike prices.
  • The upper and lower strike prices are equal distance from the middle, or at-the-money, strike price.
  • Each type of butterfly has a maximum profit and a maximum loss.

Understanding Butterflies

Butterfly spreads use four option contracts with the same expiration but three different strike prices. A higher strike price, an at-the-money strike price, and a lower strike price. The options with the higher and lower strike prices are the same distance from the at-the-money options. If the at-the-money options have a strike price of $60, the upper and lower options should have strike prices equal dollar amounts above and below $60. At $55 and $65, for example, as these strikes are both $5 away from $60.

Puts or calls can be used for a butterfly spread. Combining the options in various ways will create different types of butterfly spreads, each designed to either profit from volatility or low volatility.

Long Call Butterfly

The long butterfly call spread is created by buying 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. Net debt is created when entering the trade.

The maximum profit is achieved if the price of the underlying at expiration is the same as the written calls. The max profit is equal to the strike of the written option, less the strike of the lower call, premiums, and commissions paid. The maximum loss is the initial cost of the premiums paid, plus commissions.

Short Call Butterfly

The short butterfly spread is created by selling one in-the-money call option with a lower strike price, buying two at-the-money call options, and selling an out-of-the-money call option at a higher strike price. A net credit is created when entering the position. This position maximizes its profit if the price of the underlying is above or the upper strike or below the lower strike at expiry.

The maximum profit is equal to the initial premium received, less the price of commissions. The maximum loss is the strike price of the bought call minus the lower strike price, less the premiums received.

Long Put Butterfly

The long put butterfly spread is created by buying one put with a lower strike price, selling two at-the-money puts, and buying a put with a higher strike price. Net debt is created when entering the position. Like the long call butterfly, this position has a maximum profit when the underlying stays at the strike price of the middle options.

The maximum profit is equal to the higher strike price minus the strike of the sold put, less the premium paid. The maximum loss of the trade is limited to the initial premiums and commissions paid.

Short Put Butterfly

The short put butterfly spread is created by writing one out-of-the-money put option with a low strike price, buying two at-the-money puts, and writing an in-the-money put option at a higher strike price. This strategy realizes its maximum profit if the price of the underlying is above the upper strike or below the lower strike price at expiration.

The maximum profit for the strategy is the premiums received. The maximum loss is the higher strike price minus the strike of the bought put, less the premiums received.

Iron Butterfly

The iron butterfly spread is created by buying 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. The result is a trade with a net credit that’s best suited for lower volatility scenarios. The maximum profit occurs if the underlying stays at the middle strike price.

The maximum profit is the premiums received. The maximum loss is the strike price of the bought call minus the strike price of the written call, less the premiums received.

Reverse Iron Butterfly

The reverse iron butterfly spread is created by writing an out-of-the-money put at a lower strike price, buying an at-the-money put, buying an at-the-money call, and writing an out-of-the-money call at a higher strike price. This creates a net debit trade that’s best suited for high-volatility scenarios. Maximum profit occurs when the price of the underlying moves above or below the upper or lower strike prices.

The strategy’s risk is limited to the premium paid to attain the position. The maximum profit is the strike price of the written call minus the strike of the bought call, less the premiums paid.

Example of a Long Call Butterfly

An investor believes that Verizon stock, currently trading at $60 will not move significantly over the next several months. They choose to implement a long call butterfly spread to potentially profit if the price stays where it is.

An investor writes two call options on Verizon at a strike price of $60, and also buys two additional calls at $55 and $65.

In this scenario, an investor would make the maximum profit if Verizon stock is priced at $60 at expiration. If Verizon is below $55 at expiration, or above $65, the investor would realize their maximum loss, which would be the cost of buying the two wing call options (the higher and lower strike) reduced by the proceeds of selling the two middle strike options.

If the underlying asset is priced between $55 and $65, a loss or profit may occur. The amount of premium paid to enter the position is key. Assume that it costs $2.50 to enter the position. Based on that, if Verizon is priced anywhere below $60 minus $2.50, the position would experience a loss. The same holds true if the underlying asset were priced at $60 plus $2.50 at expiration. In this scenario, the position would profit if the underlying asset is priced anywhere between $57.50 and $62.50 at expiration.

This scenario does not include the cost of commissions, which can add up when trading multiple options.

Option Butterfly Strategy – What is a Butterfly Spread

Butterflies are neutral, cheap, low probability option strategies with relatively high potential payouts if used correctly. They have similar payoffs as calendar spreads but work quite differently. There are different ways to set up butterfly spreads. I will cover the most common ones here.

Video Breakdown:

Long Butterfly Option Strategy

Market Assumption:

When trading long butterfly spreads you should definitely have a neutral/range bound market outlook. You should expect that the price of the underlying asset only will move little. But different from Iron Condors, Strangles and Straddles butterfly spreads are much tighter and don’t allow the price to move that much. Therefore, long butterfly spreads are not suited for high probability trading. You can either set up a butterfly spread with calls or puts:

Setup:

  • Buy 1 ITM Call
  • Buy 1 OTM Call
  • Sell 2 ATM Calls
  • Buy 1 OTM Put
  • Buy 1 ITM Put
  • Sell 2 ATM Puts

This should result in a debit (Pay to open)

Profit and Loss:

As you can see on the payoff diagram a long butterfly spread is both a limited risk and limited profit strategy. The maximum profit is reached rather rarely because to achieve it the price of the underlying has to be exactly at the strike of the two short positions. This is also the reason why butterfly spreads are not very high probability strategies. Maximum drawdown, on the other hand, occurs when the price of the underlying asset is somewhere outside of the two long positions. The strikes of the two long positions are the break-even points (- commissions).

Maximum Profit: Strike of Short Option – Strike of Long Option (Width of Strikes) (*100) – Total Premium Paid – Commissions

Ex. 53 – 50 = 3 (3$ width of strikes) => 3$ *100 – 50$ (Total Premium Paid) – 5$ (Commission) = 245$ (max profit)

(a normal option contract controls 100 shares, therefore *100)

Maximum Loss: Total Premium Paid + Commissions

Ex. 50$ (Premium Paid) + 5$ (Commission) = 55$ (max loss)

Implied Volatility and Time Decay:

Time decay or the option Greek Theta works in favor of long butterfly spreads. Even though you have two long positions, the two short options still profit more from the time decay than the long positions lose from it. Time decay is highest in the last weeks before expiration.

Normally butterfly spreads profit from a drop in implied volatility (IV). This means that it is best to enter a butterfly spread in a high IV environment (IV rank over 50). But if the price moves a certain way after entry a butterfly spread can actually also profit from a rise in IV. So it depends on where the underlying price is. But I would always recommend that you enter this spread in times of high IV. But in general, IV won’t have a too large impact on butterfly spreads.

Short Butterfly Option Strategy

A short butterfly strategy is a rather uncommon strategy, because of its low probability nature and low-profit potential. I personally would not recommend a short butterfly spread. I would much rather recommend using other spreads like long straddles or strangles. These much more commonly used strategies work in a similar way but have unlimited profit potential.

Market Assumption:

If you choose to trade a short butterfly spread, you should expect a big move in the near future. The price won’t have to move as far as it would have to in some straddle strategies, but it still has to move a little. Such a small move isn’t unlikely and therefore short butterfly spreads can be used for high probability option strategies. If the underlying asset makes an even bigger move than you expect, you won’t make any more money, because of the limited profit potential of this strategy.

Setup:

  • Sell 1 ITM Call
  • Sell 1 OTM Call
  • Buy 2 ATM Calls
  • Sell 1 OTM Put
  • Sell 1 ITM Put
  • Buy 2 ATM Puts

This should result in a credit (You get paid to open)

Profit and Loss:

A short butterfly spread is a defined risk and defined profit strategy, just like you can see on the payoff diagram. The maximum profit is reached as soon as the price of the underlying asset moves a little further than one of the strikes of the short options. The maximum loss occurs when the price of the underlying is exactly at the strike of the two long positions. Max loss won’t occur too often because it only occurs on this very small spot.

Maximum Profit: Total Premium received – Commissions

Ex. 20$ Premium – 3$ = 17$ (max profit)

Maximum Loss: Strike of Short Option – Strike of Long Option (Width of Strikes) (*100) – Total Premium received + Commissions

Ex. (Strike 50 and 52) => 2$ Width * 100 – 20$ Premium + 3$ Commissions = 183$ (max loss)

(a normal option contract controls 100 shares, therefore *100)

Implied Volatility and Time Decay:

Time decay does not work in favor of a short butterfly spread. This is because it has a negative impact on the long options, which are the most valuable in this strategy. Time decay or the option Greek Theta will increase the closer you get to expiration.

A short butterfly spread usually profits from a rise in implied volatility (IV). Therefore, this strategy is best used in times of low IV (IV rank under 50). But just as said before, IV won’t have a too large impact on butterfly spreads.

Other Variations

There are a few other butterfly spread variations, like the iron butterfly option strategy. An iron butterfly is very similar compared to a normal butterfly spread. The payoff is exactly the same, but the setup is a little different. The setup reminds of a very narrow iron condor:

Setup

Long Iron Butterfly:

  • Sell 1 OTM Call
  • Buy 1 ATM Call
  • Buy 1 ATM Put
  • Sell 1 OTM Put

This should result in a debit (Pay to open)

Short Iron Butterfly:

  • Buy 1 OTM Call
  • Sell 1 ATM Call
  • Sell 1 ATM Put
  • Buy 1 OTM Put

This should result in a credit (You get paid to open)

Trader’s Note:

Iron butterflies work almost the same way as normal butterfly spreads. But a few aspects are a little different. For example, the max profit and max loss are calculated a little differently. Leave a comment if you want me to go more in-depth on iron butterflies.

Otherwise, there are even more variations of butterfly spreads, like the broken wing butterfly. Broken wing butterfly spreads work rather different than normal butterflies do and that’s why I covered them in THIS ARTICLE.

6 Replies to “Option Butterfly Strategy – What is a Butterfly Spread”

Louis,
I don’t know much about investing so I had not even heard of butterfly spreads! You certainly know your stuff! I am can see that your site and the programs you recommend would be a great education for anyone wanting to learn about the world of investing!

Hey Jessica,
You are welcome. I am so glad that you are enjoying my site.
If you want to learn more about options and want to learn a consistent profitable option strategy you should check out my education:
https://tradeoptionswithme.com/options-trading-education
I offer three different courses for complete beginners up to advanced traders. I would recommend to start with the beginner course.

It looks like butterfly spreads should be used in markets where you don’t expect much movement. If a stock has been trading in a tight range for f a long time, and you expect it to continue, then I would think a butterfly spread might be the way to go. Is my thinking correct?

I don’t have a whole lot of experience with options, but I have used them a little in the past as a short-term (few months) strategy. I think anything over that would not be a fit for options. Just my thought…

Thanks for your comment. You definitely understood when someone would wanna use butterfly spreads.

I usually don’t trade options on a very long term basis either, but I am sure that there are some option traders who do and make some good profit.

If you want to learn more about options and want to learn a consistent profitable option strategy you may want to check out the education section here.

I have noticed that in the video explanation you used any strike prices for the options used while in the script you identified the strike prices being ITM, OTM and ATM can you please explain if we need to stick to ITM, OTM and ATM or any strike price can work.

Another point is that in the video as well the script you used equidistant strike prices such as 105, 100, and 95 where the difference is constant i.e 105-100 = 5 and 100 – 95 =5 except in your last example in the video (your DIA trade) where the difference was not. Was that for the purpose of easy teaching or they should be equidistant.

Thanks for your comment.
Usually, butterflies are set up with ITM, ATM and OTM strikes. However, this does not mean that you can’t use any other strikes. You certainly can. This just depends on your directional assumption. Butterflies are most commonly used as a neutral strategy. If you use only ITM or OTM options, the butterfly will become much more directional. Furthermore, the strike selection will impact the max profit/loss and the probability of profit.

The strikes of standard butterflies are always equidistant. It doesn’t matter if the distance between them is 1, 2, 5, 10 or anything else. If the distance between the strikes varies, you get a so-called broken wing butterfly which is a different strategy.

In the DIA example in the video, I did use equidistant strike prices. But I probably didn’t present it clearly enough. For the DIA example, I chose the strike prices 211.5; 215.5 and 213.5.
212.5 was the price of DIA at the time of making this example. 212.5 was not a strike price for the example.
I hope I could clarify things. If you have any further questions or comments, don’t hesitate to let me know.

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