Bull Butterfly Spread

When to Use

The bull butterfly spread is best applied when you predict that a security will increase to a specific price within a fixed period of time; you will make a decent return if your predictions are correct, but you don't want to expose yourself to much risk. It's not the best strategy to use if you think there's a chance that the security will increase dramatically in price, because the potential profits are limited.

This is a useful strategy if you don’t have much capital to invest, because the upfront costs are low.

Establishing the Bull Butterfly Spread

The bull butterfly spread is established using three simultaneous transactions. You need to write calls with a strike that is equal to what you believe the price of the underlying security will be at the point of expiration. For every two calls written, you also need to buy one call with the next lowest strike and buy one call with the next highest strike. The money spent on calls will be largely covered by the money received for writing calls. This will result in a debit spread, but not an expensive one.

You can actually create the spread using puts in exactly the same way. The cost and the potential payoffs are pretty much the same, in theory, so it doesn’t really make much difference. However, in practice the cost of calls and puts with the same strikes can sometimes vary a little, so it may be cheaper to use one or the other.

If the net debit using calls is less than using puts, then you should use calls and vice versa. For the purposes of this article we will focus on using calls.

Profit & Loss Potential

The bull butterfly spread returns its maximum possible profit if, at the point of expiration, the price of the underlying security is equal to the strike of the calls written. When this happens, the calls you have written will expire worthless, as will the calls that you bought with the higher strike. The calls that you bought with the lower strike, though, will expire in the money.

You'll therefore be able to exercise your option to buy the underlying security at a price cheaper than it's trading for, or simply sell up (using the sell to close order) to make a return that will cover the initial debit and return a profit.

There are two break even points, a higher break-even point and a lower break-even point. Providing the price of the underlying security is somewhere between these two points at expiration, or at any time prior to expiration then if you want to close your position earlier, the strategy will be in profit. Where these break-even points lie will depend on the strikes used and the net debit paid for establishing the position.

There's a formula you can use to calculate these break-even points, which you will find further down the page along with an example of the bull butterfly spread.

Your losses are limited to the upfront cost. You'll lose this amount if the price of the underlying security doesn't go up enough for any of the options to finish in the money, because all the contracts will expire worthless. You will also lose the amount if the price of the underlying security goes up too high, above the highest strike of the calls you bought. When this happens, any returns you make from the calls owned will be offset by the liabilities of the ones written, so the initial investment will be lost.

Advantages & Disadvantages

This strategy gives a very high return on investment if you manage to accurately forecast where the price of the underlying security will be at the time of expiration. You can make a decent profit using it, and the upfront cost is low compared to many other bullish trading strategies.

The potential loss is limited to the upfront cost, so you know exactly how much you stand to lose at the outset. The spread is flexible so that you can use to it to profit from any specific price that you believe the underlying security will reach, whether it's a small price increase or a large price increase.

It isn't without its disadvantages though. For one thing, for the spread to return a decent profit you do need to be very accurate with your forecast. This is fairly difficult to do for most traders, so you will need to be very skilled in this respect if you want to consistently make money with this strategy.

Because of the number of transactions involved, this strategy also incurs higher commission fees than many others.

Example

Below is a theoretical example of the bull butterfly spread in use, and what the outcome will be in some different scenarios. This example isn't intended to be a precise illustration, because it uses hypothetical options prices, but rather a simple overview to provide an idea of how it works. No commission costs have been taken into account.

Initial Trade

• Company X stock is trading at $50, and you expect it to increase to $53.
• Calls on Company X stock with a strike price of $53 are trading at $.50.
• You write 2 of these call options contracts (each contract containing 100 options) for a credit of $100. This is Leg A.
• Calls on Company X stock with a strike price of $52 are trading at $.80.
• You buy 1 of these call options contracts (each contract containing 100 options) at a cost of $80. This is Leg B.
• Calls on Company X stock with a strike price of $54 are trading at $.30
• You buy 1 of these call options contracts (each contract containing 100 options) at a cost of $30. This Leg C.
• With the combined cost of $110 and the credit received of $100, you have created a bull butterfly spread for a $10 debit.

If Company X stock increases to $53 by expiration

The calls in Leg A and Leg C will expire worthless. The ones in Leg C will be worth around $1 each for a total of $100. Minus your initial investment of $10, you have made a $90 profit.

If Company X stock increases to $55 by expiration

The calls written in Leg A will be worth around $2 each for a total liability of around $400. The ones bought in Leg B will be worth around $3 each, for a total of $300. The ones bought in Leg C will be worth around $1 each, for a total of $100. The options you own will roughly offset the liability of the ones written in Leg A. Your overall loss will be the original $10 debit. The same will be true if the stock is any higher than $55.

If Company X stock remains at $50 by expiration

All of the calls you have bought will be worthless. The ones you have written will also be worthless. Your loss will be your initial $10 investment. The same will be true if the stock falls below $50.

Profit, Loss & Break-Even Calculations

• Maximum profit is limited.
• Maximum profit is made when “Price of Underlying Security = Strike Price of Leg A”
• Maximum profit, per option in Leg B, is “(Strike Price of Leg A – Strike Price of Leg B) – (Net Debit /Number of Options in Leg B)”
• Maximum loss is limited to the net debit paid to establish the spread.
• Maximum loss is made when “Price of Security > or = Strike Price of Leg C” or “Price of Security < or = Strike Price of Leg C”
• The break-even points when using the bull butterfly spread will vary depending on the strike prices used and the price of the options involved. We would recommend that you carry out your own calculations to work out where the break even points will be.

Summary

The bull butterfly spread is a very effective trading strategy if you can accurately predict what price a security is going to increase to, and it has a low upfront cost and limited loss. However, although the returns are good when your forecast is accurate, it does only generate a return within a fairly tight range.

Therefore, this strategy is only recommended when you have a lot of confidence about exactly where the price of a security is going to go. There are better strategies to use if you are expecting a security to rise in price, but aren't really sure by how much.