Exploring Butterfly Spread Strategies in Options Trading
Investors can use different options strategies to help them meet their investment goals and navigate the market. One advanced strategy, the butterfly spread, involves a combination of various options with different strike prices. It’s designed to help traders potentially profit from low volatility in the underlying asset while limiting potential losses.
Read on to learn more about butterfly spreads.
What is a butterfly spread?
A butterfly spread is an advanced options strategy that involves setting up positions with three different strike prices to potentially profit from minimal movement in the underlying asset's price. Implemented using either all calls or all puts, the strategy typically involves buying one in-the-money option (ITM), selling two at-the-money options (ATM), and buying one out-of-the-money (OTM) option.
The goal is to potentially profit from the underlying asset's price staying close to the middle strike price, with limited risk due to offsetting positions. Some investors may use this strategy if they anticipate low volatility in the underlying asset and are considering a strategy with defined risk and potential reward.
How does a butterfly spread work?
A butterfly spread combines both bull and bear spreads and includes four options with the same expiration date but three different strike prices. With a goal for the stock price to be as close as possible to the strike price of the ATM options at expiration, the strategy can potentially yield profits if the price stays within a narrow range close to the ATM options’ strike price.
Take a look at the three strike prices for the options by reviewing these examples:
Buy one call option at the lower strike price: This example of a long call sets the lower boundary of the expected price range.
Sell two call options at the middle strike price: Selling these calls caps the maximum profit and helps offset the cost of the long calls.
Buy one call option at the higher strike price: This long call sets the upper boundary and limits the potential loss.
The net result is a debit spread, meaning the trader pays a net premium to establish the position. The theoretical maximum profit is achieved when the price of the underlying asset is exactly at the middle strike price at expiration, and the theoretical maximum loss is limited to the net premium paid; it occurs if the price falls below the lower strike price or rises above the upper strike price by expiration.
Types of butterfly spreads
Butterfly spread options can be used for put and calls. These strategies involve using multiple options contracts with different strike prices but with the same expiration date. They are called "butterfly" spreads because the risk-reward profile typically resembles the shape of a butterfly when plotted on a graph.
Keep reading to learn about different types of butterfly spread strategies.
Long call butterfly spread
A long call butterfly spread may be used to potentially profit from minimal price movement in the underlying asset. Note that the high and low strike prices are equidistant from the middle (ATM) strike price.
Buy one ITM call option (low strike).
Sell (write) two ATM call options.
Buy one OTM call option (high strike).
Maximum profit occurs if the underlying price equals the written calls’ strike price at expiration.
The high and low strike prices are equidistant from the middle (ATM) strike price.
Here's an example:
Buy one call option with a strike price of $55
Sell (write) two call options with a strike price of $60
Buy one call option with a strike price of $65
The net premium paid for the spread is $2.
Theoretical maximum profit: The difference between the lowest and middle strike prices, minus the net cost of the position (including commissions). This profit is achieved if the stock price is below the lowest strike price or above the highest strike price.
($60−$55)−$2= $5−$2=$3 theoretical maximum profit (100 options multiplier x 3 = $300)
Theoretical maximum loss: The maximum risk is the total cost of the strategy, including commissions.There are two scenarios where this maximum risk is realized.
First, if the stock price is below the lowest strike price at expiration ($55), all the call options expire worthless, and the entire cost of the strategy, including commissions, is lost.
Second, if the stock price is above the highest strike price at expiration ($65), all the call options are in the money, and the butterfly spread position has a net value of zero at expiration.
Short call butterfly spread
With a short call butterfly spread, an investor is trying to capitalize on an upward or downward movement in the underlying asset. This three-part strategy aims to potentially profit from a stock price move up or down beyond the highest or lowest strike prices of the position.
Sell 1 ITM call option (low strike price)
Buy 2 ATM call options (middle strike price)
Sell 1 OTM call option (high strike price)
All calls have the same expiration date.
Let's use an example with the underlying stock trading at $100.
Sell 1 95 call at $6.40
Buy 2 100 calls at $3.30 each (total cost: $6.60)
Sell 1 105 call at $1.45
Net credit received: $1.25
Theoretical maximum profit: The net credit (premium received) when selling the options less commissions.
In this example, it's $1.25, net premium (overall premium received less commissions) and the underlying stock price at expiration is either below the lower ($95) or above the upper strike price ($105).
Theoretical maximum loss: Stock price at expiration is exactly the same as the strike price of the two middle long calls.
For this example, the trader would lose $5.00 of the $6.40 collected on the lower strike price call. The total premium collected was $6.40 + $1.45, or $7.85, and the trader would be left with $1.40 + $1.45 equalling $2.85 - $6.60 for a theoretical max loss of $3.75.
Long put butterfly spread
A long put butterfly spread is an options trading strategy designed to profit from low volatility in the underlying asset, where the trader anticipates the asset's price to be at a specific level at expiration. This strategy involves three different strike prices and typically requires four options contracts.
Buy one ITM put option (lower strike price)
Sell two ATM put options (middle strike price)
Buy one OTM put option (higher strike price)
All options have the same expiration date.
Let's use an example with a stock trading at $50.
Buy 1 put option with a strike price of $45 (lower strike price) at $3
Sell 2 put options with a strike price of $50 (middle strike price) at $6
Buy 1 put option with a strike price of $55 (higher strike price) at $2
Theoretical maximum profit: The theoretical maximum profit equals the difference between the highest and center strike prices, less the net cost of the position happens when the underlying asset's price is at the middle strike price at expiration ($50.)
In this scenario, the difference between the highest and center strikes is $5 and the net cost was $1 (excluding commissions). The maximum profit is $4 (excluding commissions.)
Theoretical maximum loss: Occurs if the stock price is below the lower strike ($45) or above the higher strike ($55), and it is equal to the net cost of the strategy. It happens at when stock price equals the middle strike price at expiration.
Short put butterfly spread
An investor can potentially profit from a stock price increasing up or down beyond the position's highest or lowest strike prices.
Sell one put option at a higher strike price.
Buy two put options at lower strike prices.
Sell one put option at an even lower strike price.
All puts have the same expiration date, and the strike prices are equidistant.
Here's an example.
Sell 1 ITM 105 put for $6 (higher strike price)
Buy 2 ATM 100 puts for $3 each ($6 total) (middle strike price)
Sell 1 OTM 95 put for $1.25 (low strike price)
Net credit = $1.25
Theoretical maximum profit: Equal to the net credit received, less commissions. In this example, it would be $1.25, less commission.
Theoretical maximum loss: Difference between the middle strike price and the lowest strike price, minus the net credit received, less commissions. In this example, it's $5 (100 - 95) minus the net credit of $1.25, resulting in a theoretical maximum loss of $3.75 per share, less commissions.
The maximum loss happens
Maximum potential loss and profit for options are calculated based on the single leg or an entire multi-leg trade remaining intact until expiration with no option contracts being exercised or assigned. These figures do not account for a portion of a multi-leg strategy being changed or removed or the trader assuming a short or long position in the underlying stock at or before expiration. Therefore, it is possible to lose more than the theoretical max loss of a strategy.
How to trade a butterfly spread on moomoo
Moomoo provides a user-friendly options trading platform. Here's a step-by-step guide to get you started:
Step 1: Navigate to your Watchlist, then select a stock's "Detailed Quotes" page.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 2: Navigate to Options> Chain located at the top of the page.
Step 3: By default, all options with a specific expiration date are shown. For selective viewing of calls or puts, simply tap "Call/Put."
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 4: Adjust the expiration date by choosing your preferred date from the menu.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 5: Easily distinguish between options: white denotes out-of-the-money, and blue indicates in-the-money. Swipe horizontally to access additional option details.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 6: Explore various trading strategies at the screen's bottom, offering flexibility for your investment approach.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Long butterfly vs. Long straddle
A "long butterfly" is an options strategy designed to profit when the underlying asset price stays relatively near a specific range, while a "long straddle" potentially profits when the underlying asset price moves significantly in either direction, regardless of the specific price level.
The key difference is that a butterfly has a limited profit potential but also a limited risk due to its centered strike prices, whereas a straddle has a larger potential profit but also a higher cost due to buying options at the same strike price (often at-the-money), both call and put, making it more sensitive to large price movements.
Here are some additional differences.
Complexity: The long butterfly strategy involves four contracts and three different strike prices, making it more complex compared to the short straddle with its two types of options (one strike price and typically two contracts).
Market conditions: The long butterfly strategy is for low volatility environments with an expected narrow trading range, while the long straddle can benefit from high volatility and significant price movement in either direction.
Risk and reward: Butterfly strategies offer capped profit and limited risk assuming they remain intact, providing a conservative approach while a long straddle offers unlimited profit potential but with higher risk due to the substantial premium paid.
Profitability range: The long butterfly strategy can profit within a narrower range around the middle strike price while the long straddle potentially profits if theunderlying asset's price moves considerably away from the strike price, either upwards or downwards.
Breakeven range: A long butterfly has a narrower breakeven range, and the price of the underlying asset needs to stay close to the middle strike to make a profit. A long straddle has a wider breakeven range, and the price must move significantly in either direction for the strategy to be profitable, reflecting its reliance on large price movements.
Potential pros and cons of the long butterfly spread
The long butterfly spread can be an effective strategy for option traders seeking limited risk exposure and profit potential in low volatility environments.
Potential Pros
Limited risk: Involves buying and selling options with different strike prices, the theoretical maximum loss is predefined and limited to the initial cost of entering the trade.
Defined profit potential: Well-defined. Can be advantageous for traders who prefer a clear understanding of their potential gains.
Potential profit from low volatility: If the underlying asset's price remains within a certain range until expiration, the spread can potentially yield a profit due to time decay.
Versatility: Can be constructed with various strike prices and expiration dates to tailor the strategy to specific market conditions or price expectations. Traders can tailor the spread's width and positioning to accommodate different risk tolerances and potential profit objectives.
Potential Cons
Limited profit potential: Profit potential is capped. The theoretical maximum profit is achieved when the underlying asset's price settles at the middle strike price at expiration.
Sensitive to timing and volatility: Sensitive to changes in time decay and volatility. If the underlying asset's price moves too quickly or if volatility increases significantly, it can negatively affect the spread's value and potentially lead to losses.
Complex management: Managing a butterfly spread can be more complex compared to simpler options strategies. Traders may need to adjust the position or close it out before expiration to realize potential profits or minimize losses, which requires active monitoring and decision-making.
Transaction costs: Entering and exiting options positions typically involve transaction costs, such as commissions. These costs can cut into potential profits.
FAQs about the butterfly spread
When should I consider using a butterfly option strategy?
A long butterfly option is typically used when an options trader expects the price of the underlying asset to remain within a specific range, with minimal movement. It's a neutral strategy that may profit from low volatility. Additonal times to consider using it include when looking to generate potential income through premiums received, leading up to earnings announcements, and seeking a pre-defined risk profile.
Is a butterfly spread risky?
Butterfly spreads can be considered risky depending on how they're structured and the market conditions. A long butterfly spread involves trading options contracts with three different strike prices to create a position that profits from a narrow range of prices. They do come with risks including limited potential reward compared to other strategies, time decay and volatility risk if the price moves away from the middle strike and sensitivity to price movement outside of the break-even range.
When should I consider selling a butterfly spread?
Deciding when to sell a butterfly spread depends on your outlook for the underlying asset, current market conditions, and profit objectives. Some considerations to help you determine when to sell a butterfly spread to close your position can include:
If the underlying asset reaches your target price or price range, it might be a good time to consider selling the butterfly spread.
If you've reached a point where the majority of the time value has decayed, and you've achieved a significant portion of your potential profit, it might be a good time to sell the spread.
If volatility increases, the price of a long butterfly spread decreases (the spread loses money) and when volatility declines, the long butterfly spread price increases (the spread makes money).
If your target profit is reached, you may want to consider closing the spread to lock in your gains.
If you're trading options with short expiration dates, such as weekly or monthly options, you may need to act more quickly to capture potential profits or cut losses compared to longer-term options.
Is a long butterfly spread bullish or bearish?
A butterfly spread is generally considered a neutral strategy, rather than strictly bullish or bearish. It profits when the price of the underlying asset remains near a specific price (the middle strike) at expiration. The strategy is typically used when the trader expects low volatility and believes that the price will stay within a narrow range.
