Butterfly spread: a speculative options strategy
There are many different options strategies to try to succeed on the stock market, such as the strangle or straddle . The butterfly spread is a well-known options strategy. How does the strategy work and when can you use it as an investor? In this blog you can read everything you need to know about the options strategy: butterfly spread.
Butterfly spread, what is it actually?
Butterfly spreads are strategies used by options traders. An option is a financial instrument that bases its value on an underlying asset. Want to read more about what an option is? Then check out our article on: What are options ?
The term butterfly spread refers to a strategy that plays on the expectation that the underlying asset will fall within (or outside) a certain bandwidth at the time the options expire (expire). The butterfly spread is therefore mainly a strategy if you expect little movement in the market.
A butterfly spread consists of four options with the same expiration date but three different strike prices:
- A higher strike price
- An at-the-money strike price
- A lower strike price
The two options that are purchased have different strike prices, the two options that an investor writes have the same 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, then the upper and lower options should have strike prices equal to amounts above and below $60. For example, $55 and $65, since these strike prices are both $5 away from $60.
Both call and put options can be used for a butterfly spread. By combining the options in different ways, different types of butterfly spreads are created.
Long butterfly with call options
The long butterfly spread with call options is created by buying an in-the-money call option with a low strike price, writing two at-the-money call options, and buying an out-of-the-money call option with a higher strike price.
The transaction of a long butterfly spread starts as follows: the 2 written options immediately yield premium while the 2 purchased options cost premium. The difference between these determines how much the position initially costs.
The maximum profit is achieved when the price of the underlying asset at expiration is equal to the written calls. The maximum profit is equal to the strike price of the written option, minus the strike price of the lower call, the premiums and the commissions paid. The maximum loss is the initial cost of the premiums paid, plus commissions.
Short Butterfly Spread with call options
The short butterfly spread with call options is created by selling a call option with a lower strike price, buying two at-the-money call options, and selling a call option with a higher strike price. A net profit is created when the position is entered into. This position maximizes its profit if the underlying asset price at expiration is above or below the upper strike price or the lower strike price.
The maximum profit is equal to the initial premium received, minus the price of the commissions. The maximum loss is the strike price of the purchased call option minus the lower strike price, minus the premiums received.
Long Butterfly Spread with Put Options
The long put butterfly spread is created by buying a put option with a lower strike price, selling two at-the-money puts, and buying a put option with a higher strike price. When the position is entered into, a net debt is created. Like the long call butterfly, this position has a maximum profit when the underlying asset remains at the strike price of the middle options.
The maximum profit is equal to the higher strike price minus the strike price of the put sold, less the premium paid. The maximum loss of the trade is limited to the initial premiums and commissions paid.
Short Put Butterfly Spread
The short put butterfly spread is created by writing an out-of-the-money put option with a lower strike price, buying two at-the-money puts, and writing a put option with a higher strike price. This strategy realizes its maximum profit if the price of the underlying asset is above the upper strike price or below the lower strike price at expiration.
The maximum profit for the strategy is the premium received. The maximum loss is the higher strike price minus the strike price of the purchased put, minus the premiums received.
When do you use the butterfly spread?
With the butterfly spread, investors speculate on the price movement of an underlying asset. With a long butterfly strategy, the price is expected to move within a certain bandwidth. With a short butterfly strategy, the price is expected to move outside the predetermined bandwidth.
The value of a butterfly spread depends on the volatility of the underlying asset.
Benefits of butterfly spread
- Limited risk compared to other options strategies
- Good risk/reward ratio
- Small investment required
Disadvantages of butterfly spread
- High transaction costs, since you are purchasing multiple options
- Maximum profit is rarely achieved
- With a narrow bandwidth the chance of success is low