Butterfly Spread

When to Use a Butterfly Spread

The butterfly spread is best used when the expectation is that the price of a security won't move, or that it will only move by a very small amount. It makes the most profit when the price of a security doesn't move at all, and it will return a loss if the price of the security moves substantially in either direction.

Unlike some neutral trading strategies the losses are limited, which means it's worth considering when you do believe that the price of the security will stay the same but have some concerns it could possible move substantially. It's a strategy that is more suited to experienced traders than beginners, because it's complex and requires a fairly high trading level.

How to Establish a Butterfly Spread

There are three orders you must place with your broker to establish this spread. You can choose to place these orders simultaneously or you can choose to leg into the spread to maximize profitability and/or reduce the upfront cost. As we have already mentioned above, it can be created using either calls or puts options; for the purposes of this guide, we have used calls. The following three transactions are required:

• Buy in the money calls.
• Buy the same amount of out of the money calls.
• Write twice as many at the money calls.

All contracts should have the same expiry date, which can be as near term or as long term as you like. A relatively near term expiration date is probably best, because the underlying security then has less time to move.

In terms of the strikes, the in the money contracts and the out of the money contracts should use strikes that are equidistant from the current trading price of the underlying security. You must decide how far these strikes should be from the current trading price, and this decision affects the strategy in two ways.

By using strikes that are close to the current trading price, you'll have a relatively small price range to profit from. By using strikes that are far from the current trading price, you'll have a larger range to profit from but the upfront cost will be higher.

Here is an example of how you might establish a butterfly spread. Please note that this example doesn't use real market data, and it doesn't include commission charges. It's a simplified example just to provide an idea of how the strategy works.

• Company X stock is trading at $50, and your expectation is that the price will remain fairly close to that price.
• You buy 1 contract (100 options, $4 each) of in the money calls (strike $47) for a $400 cost. This is Leg A.
• You buy 1 contract (100 options, $.50 each) of out of the money calls (strike $53) for a $50 cost. This is Leg B.
• You write 2 contracts (200 options, $2 each) of at the money calls (strike $50) for a credit of $400. This is Leg C.
• You have created a butterfly spread for a total cost of $50.

Profit & Loss Potential

The return generated is highest when the price of the underlying security remains exactly the same by expiration i.e. it's equal to the strike of the options written in Leg C. The options written in Leg C and the ones bought in Leg B will expire worthless when this is the case. The ones bought in Leg A will be in the money though, and worth enough to return a decent profit on the initial investment.

This strategy will also return a profit should the price of the underlying security move in either direction, providing it doesn't move too far. There are calculations to work out where the break even points are, which we have included further down the page.

The butterfly spread will result in a loss if the price of the underlying security moves too far in either direction. If it falls dramatically, then all the options will expire worthless and you will have no further returns, no liabilities, and you will lose your initial investment. If it increases substantially, then the calls owned will increase in value, but so will the calls written. These should roughly offset each other, meaning your loss will be the initial upfront cost.

Below we have provided some example outcomes, the relevant calculations for working out the potential profits, and the break-even points.

• If the price of Company X stock remained exactly at $50 by the time of expiration, the options bought in Leg A would be worth around $3 each ($300 total value) and the ones in Legs B and C would be worthless. After accounting for the initial investment of $50, you will have made a $250 profit.
• If the price of Company X stock went up to $55 by the time of expiration, the options bought in Leg A would be worth around $8 each ($800 total value), and the ones bought in Leg B would be worth around $2 each ($200 total value). The ones written in Leg C would be worth around $5 each ($1,000 total liability). The value of the options owned would offset the liability of the ones written, and you would lose the initial investment of $50.
• If the price of Company X stock went down to $45 by the time of expiration, the options in Legs A, B, and C would all expire worthless. You would lose the initial investment of $50.
• Maximum profit is made when “Price of Underlying Stock = Strike in Leg C”
• Maximum profit is “((Strike of Options in Leg C – Strike of Options in Leg A) x Number of Options in Leg A) – Initial Cost”
• There are two break-even points (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 returned if “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
• A loss is returned if “Price of Underlying Security > Upper Break-Even Point or < Lower Break-Even Point”

You can, of course, close the position at any point prior to expiration if it's in profit and you want to take that profit.

Variations of the Butterfly Spread

We have already mentioned two variations of this spread: the call butterfly spread uses calls as per example and the put butterfly spread is constructed in the same way, but the calls are replaced with puts.

There's also a variation known as the broken wing butterfly spread, where the out of the money options are bought at a strike that is further away from the current price of the security than the strike of the in the money options bought. By doing this, you will reduce the cost of applying the strategy. This variation can also be known as the skip strike butterfly spread.

When using this approach with calls (a call broken wing butterfly spread) you basically reduce, or even eliminate, the losses if the price of the underlying security should fall, but increase the losses if it should go up. If you use this approach using puts (a put broken wing butterfly spread), then you reduce or eliminate the losses, if the underlying security should rise in price and increase the losses if it falls in price.

Summary

The butterfly spread can offer a high return on investment if the underlying security doesn't move at all, and it can still make a profit even if it moves slightly. It has a set maximum profit and maximum loss that can be calculated at the time of establishing the spread, which is useful when it comes to planning trades.

The main disadvantage is that, with three transactions involved, the commission costs can be quite high.