Short Butterfly Spread

When to Use the Short Butterfly Spread

The short butterfly spread is designed to be used when you have a volatile outlook and are expecting a security to make a substantial price movement, but you aren't certain in which direction. It's actually quite a flexible strategy, and you can adjust it depending on how much you think the price will move by and how much profit you want to try and make. Therefore, you could also use it if you are expecting a fairly moderate movement rather than a substantial one.

This is a complicated strategy, so would advise that beginner traders don't use it until they have gained a decent level of experience.

How to Apply the Short Butterfly Spread

To apply the short butterfly spread you must make a total of three transactions. As we have mentioned above, you can use either calls or puts. For the purposes of this article we will be focusing on using calls, but the principle is basically the same whichever you use. The three transactions can be placed simultaneously or you can use legging techniques if you prefer.

The required transactions are as follows.

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

It's up to you to choose what expiration date you want to use, but you should use the same date for each leg. The big decision is what strike prices to use for the options you write. The strikes should be an equal distance from the current trading price of the underlying security – i.e. the out of the money calls should be as far out of the money as the in the money calls are in the money. You need to decide just how far away the strikes are from the price of the security though.

If you use strikes that are quite close together, then you won't require a particularly big price movement to make a profit, but the profit will be relatively small. If you use strikes that are further away from each other you can make a larger profit, but it will require a greater price movement.

We have provided an example of how you might apply the short butterfly spread below. As with all our examples, we keep it simple by using rounded numbers instead of real market data and not including commission costs.

• Company X stock is trading at $50, and your expectation is that the price will make a big price move, but you don't know in which direction.
• You write 1 contract (100 options, $4 each) of in the money calls (strike $47) for a credit of $400. This is Leg A.
• You write 1 contract (100 options, $.50 each) of out of the money calls (strike $53) for a credit of $50 cost. This is Leg B.
• You buy 2 contracts (200 options, $2 each) of at the money calls (strike $50) at a cost of $400. This is Leg C.
• A short butterfly spread has been created for a total net credit of $50.

Potential for Profit & Loss

The short butterfly spread will return a profit if the price of the underlying security moves sufficiently, but it will result in a loss if it stays stable or only moves a little.

It's fairly straightforward to calculate the potential maximum profit and potential maximum loss of the spread, along with break-even points. We have provided the necessary calculations below, after some hypothetical scenarios based on our example.

• If the price of Company X stock remained at $50 by expiration, then options written in Leg A would be worth around $3 each ($300 total value) and the options in Legs B and C would be worthless. You would have a total liability of $300, only partially offset by the initial credit received of $50. Your total loss would be $250.
• If the price of Company X stock went up to $54 by expiration, the options written in Leg A would be worth around $7 each ($700 in total), and the ones written in Leg B would be worth around $1 each ($100 in total). This would give you a total liability of $800. The options bought in Leg C would be worth around $4 each ($800 total value). The value of the options owned would offset the liability of the ones written, and you would retain the initial net credit of $50 as your profit.
• If the price of Company X stock went down to $46 by expiration, the options in all legs would be worthless. You would retain the initial net credit of $50 as your profit.
• Maximum profit is made when “Price of Underlying Stock < or = Strike in Leg A” or “Price of Underlying Stock > or = Strike in Leg B”
• Maximum profit is “Total Net Credit Received”
• The short butterfly spread has two break-even points (Upper Break- Even point and Lower Break-Even Point)
• Upper Break-Even Point = “Strike of Leg B - (Net Credit/Number of Options in Leg B)”
• Lower Break-Even Point = “Strike of Leg A + (Net Debit/Number of Options in Leg A)”
• The short butterfly spread will result in a loss if “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
• Maximum loss is made when “Price of Underlying Security = Strike of Leg C”

Summary

The short butterfly spread is a complicated trading strategy that requires some thought, but it offers flexibility and the ability to make a profit from the price of the underlying security moving in either direction. The maximum potential loss and the maximum potential profit are both limited (and can be calculated at the time of applying the strategy), which is good for planning trades and managing risk.

This isn't a suitable strategy for beginners, but experienced traders should certainly consider it in the right circumstances.