• Skip to primary navigation
  • Skip to main content
  • Skip to primary sidebar

Epsilon Options

Options Trading Education

  • Home
  • How Options Work
    • In The Money (ITM) Options
    • Puts and Calls Explained
    • Learn Options Trading
    • LEAP Options Explained
    • Put Call Parity
    • Buy to Open vs Buy to Close
    • Out Of The Money (OTM) Options
    • Strike (Exercise) Price
    • Implied Volatility
    • Volatility Skewness | IV Skew In Options
  • Options Greeks
    • Delta
    • Vega
    • Gamma
    • Theta
    • Rho
  • Options Spreads
    • Long Call
    • Long Put
    • Bear Put Spread
    • Iron Condor
    • Bull Call Spread
    • Covered Calls
    • Synthetic Covered Call
    • Buying Straddles Into Earnings
    • Covered Call LEAPs
    • Calendar Spread
    • Backspread
    • Strangle
    • Butterfly
    • Protective Put
    • Long Box Spread
    • Straddle
    • Vertical Spread
    • Zero Cost Collar
  • Options Brokers Reviews
  • Blog
  • Show Search
Hide Search

Options Trading Strategy: Butterfly Spread

Table of Contents

  • Introduction To Butterfly Spreads
  • Description of the Strategy
  • When to Put it on
  • Pros of Strategy
  • Cons of Strategy
  • Risk Management
  • Possible Adjustments

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

Options Strategy: Butterfly Spread

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.

facebookShare on Facebook
TwitterTweet
PinterestSave

Further Reading On Options Trading...

Covered Call LEAPs | Using Long Dated Options In A Covered Call Write

The 'Covered Call LEAPs' options strategy is a capital efficient alternative to the more traditional Covered Call, replacing the owned stock with a LEAP call option. What's A Covered Call? ...
Read More

Options Trading Strategy: Bear Put Spread

Introduction Options can be an extremely useful tool for short-term traders as well as long-term investors. Options can provide investors with a vehicle to bet on market direction or volatility, ...
Read More

Strangle Spread: A Guide To This Options Trading Strategy

The Strangle Spread Options Trading Strategy Introduction Options, and combination trades such as the strangle spread, can be a very useful tool for both novice and seasoned traders and investors ...
Read More

Options Trading Strategy: Long Put

What Is A Long Put? A long put option strategy is the purchase of a put option in the expectation of the underlying stock falling. It is delta negative and ...
Read More

Extrinsic Value In Options Trading

What is Extrinsic Value In Options Trading? The extrinsic value of a stock option contract is the portion of the option's worth that has been assigned to factors other than ...
Read More

LEAP Options Explained: What Are They And How Do They Work?

Investors that are looking to make longer-term bets may use LEAP Options. Description of LEAP Options A LEAP option is essentially an option with longer terms than standard options. The ...
Read More

Put Call Parity

Put Call Parity Introduction Options trading can be relatively simple and can also become highly technical. One of the most important basic concepts when it comes to trading options is ...
Read More

Options Spreads: Put & Call Combination Strategies

Options Combinations Explained Options spreads involve the purchase or sale of two or more options covering the same underlying stock or security (ref). These options can be puts or calls ...
Read More

Options Trading Strategies: Call And Put Backspreads

Backspreads: Extreme Bullish Or Bearish Options Trading Strategies What Are Backspreads? A backspread is very bullish or very bearish strategy used to trade direction; ie a trader is betting that ...
Read More

Options Trading Strategy: Butterfly Spread

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 ...
Read More

Options Delta Explained: Sensitivity To Price

Options Delta is the measure of an option’s price sensitivity to the underlying stock or security’s market price. It is the expected change in options price with a 1c change ...
Read More

Options Vega Explained: Price Sensitivity To Volatility

Options Vega is the measure of an option’s price sensitivity to changes in volatility. It is the expected change in options price with a 1 point change in implied volatility ...
Read More

Call Option Payoff

A call option payoff depends on stock price: a long call is profitable above the breakeven point (strike price plus option premium). The opposite is the case for a short ...
Read More

Sell to Open vs Sell to Close

What is Sell to Open vs Sell to Close? We look at these two similar, but not exactly the same, concepts. There are two ways to participate in the options ...
Read More

How To Learn Stock Options Trading: Stock Options For ‘Dummies’

Would you like to learn stock options trading but don't know where to start? Well we've got your back and designed this step by step guide on how to educate ...
Read More

Primary Sidebar

Featured Posts:

Options Spreads: Put & Call Combination Strategies

Protective Put: This Defensive Put Option Strategy Explained

Options Greeks: Theta, Gamma, Delta, Vega And Rho

How To Learn Stock Options Trading: Stock Options For ‘Dummies’

LEAP Options Explained: What Are They And How Do They Work?

Options Trading Strategy: Butterfly Spread

Copyright © 2023 · Monochrome Pro on Genesis Framework · WordPress · Log in

  • Facebook
  • Twitter
  • Pinterest
  • Privacy Policy