Introduction To Butterfly Spreads

Options can provide traders and investors a tool for expressing different market opinions. Options can be used to make trades based on market direction, to bet on changes in implied volatility or to collect premium. They can even be used to hedge risk on a long or short position in the underlying asset. Options trades can be very complicated or very simple. One of the simplest trades to learn is the butterfly spread.

The Butterfly Spread

Description of the Strategy

The butterfly spread can use either calls or puts, and is really two spreads combined into one. A butterfly spread using calls would entail the purchase of a call, the sale of two calls further away and then the purchase of another call even farther away.

A butterfly spread using puts would consist of the purchase of a put, the sale of two puts further away and the purchase of another put even farther away.

One way to view the butterfly spread using calls is the purchase of a bull call spread with the sale of a bull call spread. The same can be said for a butterfly spread using puts.

For example: Suppose that a trader is bullish on stock BBB, which is currently trading at $40 per share.

The trader believes that the stock could rise to $45 or so in the coming weeks, and wants to establish a position that could potentially profit if the stock does in fact climb to $45.

Rather than purchasing an outright at-the-money call which is very expensive, the trader elects to purchase the $40/$45/$50 call butterfly. The trader does this by purchasing a $40 call, selling two of the $45 calls and buying a $50 call for a total premium of $1.

The maximum profit potential of the position is calculated by taking the difference in strike prices ($5) minus the premium paid ($1) for a total profit potential of $4.

The maximum profit is achieved if the stock is at the $45 strike price level at expiration. If the market moves above $45, profit will be reduced until it reaches the break-even level of $49. The trade loses money if the market is above $49 at expiration or below $41 at expiration.

When to Put it on

The butterfly spread can be useful when the trader has a directional opinion on the market or believes that the market is likely to stay within a specified range.

The call butterfly may be appropriate if the trader thinks the market may see a moderate price rise. In the case of a put fly, the spread may be used if the trader thinks the market could see a moderate decline.

The butterfly spread may also be used if IV levels are very high, making a straight call spread or put spread too expensive.

The call fly is effectively buying a call spread closer to the money while selling a call spread that is farther from the money. The put fly is buying a put spread closer to the money while selling a put spread that is farther from the money.

Pros of Strategy

The butterfly spread can have some important advantages. Butterfly spreads are limited in risk. If a trader buys a butterfly spread, their risk is limited to the net premium paid for the position.

If the trader sells a butterfly spread, their risk is limited to the difference in strike prices minus the premium collected.

The butterfly spread can potentially profit not only from price action, but also from favorable changes in IV levels.

Cons of Strategy

The butterfly spread does have some disadvantages as well. The spread can be negatively affected by unfavorable changes in IV levels.

It may also require the market to stay within a fairly tight range in order to turn a profit. Because the spread uses multiple legs, it can also cost more in commissions and fees.

Risk Management

There are numerous ways to manage risk on a butterfly spread. If a trader is long a call fly for a premium of $4, he or she could elect to cut the position if the value of the spread declines by half. Butterfly spreads can also be managed using price action.

For example, if the trader buys a $40/$45/$50 call fly on a stock and the stock reaches $45, he or she could elect to cut the trade even if the max profit has not yet been reached.

If the trader has sold a call fly or a put fly, they can set a premium level at which they will exit the trade. For example, if a trader sold a call fly for $1, he or she may decide to cut the trade if the value of the fly increases to $2.

Possible Adjustments

The butterfly spread can be adjusted any time during the trade. A trader could elect to close one or more legs of the trade at any time. This could, however, increase risk exposure or even expose the trade to unlimited risk.

Traders also have the option of rolling the fly up or down using different strike prices.

Traders can also elect to sell a fly back to the market, and to buy a new fly with more time until the options expire. Conversely, a trader that is short a fly can buy it back and sell a new fly with more time.

Traders can also use a variation of the butterfly where one portion of the spread, known as the wing, is larger. For example, a trader could buy the $40 call, sell two of the $45 calls and purchase a $52 call.

The structure of the trade can be made according to the trader’s market forecast, risk tolerance and profit objectives.

The butterfly spread is extremely versatile, and can be used under a variety of market scenarios. It is a fairly simple spread to grasp, and may put the trader in a position to potentially profit while keeping trade risk limited.