💡What is a Butterfly Spread?
A butterfly spread is an options trading strategy that involves buying and selling options on the same underlying asset with the same expiration date but different strike prices. This strategy is employed when traders expect the underlying asset's price to remain within a specific range.
How Do Butterfly Spreads Work?
Buying Options: In a butterfly spread, the trader buys one in-the-money (ITM) call option, sells two at-the-money (ATM) call options, and buys one out-of-the-money (OTM) call option with the same expiration date. The strike prices of the options form a symmetric pattern.
Payoff Structure: The payoff structure of a butterfly spread resembles a butterfly's wings, with limited risk and reward potential.
Payoff Structure of Butterfly Spreads
The payoff of a butterfly spread depends on the price of the underlying asset at expiration. Here's how it works:
- Maximum Gain: The maximum gain is achieved when the underlying asset's price at expiration is equal to the strike price of the ATM options. At this point, the profit potential is at its highest, and it is calculated as the difference between the strike prices minus the initial cost of the spread.
- Maximum Loss: The maximum loss occurs when the underlying asset's price at expiration is outside the range of the strike prices. The loss is limited to the initial cost of the spread.
- Breakeven Points: In a butterfly spread, there are two breakeven points. The upper breakeven point is the strike price of the ITM call option plus the cost of the spread, while the lower breakeven point is the strike price of the OTM call option minus the cost of the spread.
Considerations for Butterfly Spreads:
- Range-Bound Market: Butterfly spreads are suitable when traders expect the underlying asset's price to remain relatively stable within a specific range. They are most profitable when the price remains close to the strike price of the ATM options at expiration.
- Limited Profit Potential: Butterfly spreads have a limited profit potential, as the underlying asset's price must remain within a specific range for optimal results. Traders should consider whether the potential profit justifies the costs involved.
- Time Decay: Butterfly spreads are affected by time decay, meaning the value of the options may decrease as expiration approaches. Traders should consider the impact of time decay when selecting the duration of their spreads.
- Adjustments: If the underlying asset's price starts moving significantly beyond the range of the strike prices, traders may need to make adjustments to minimize potential losses or take profits.
Takeaways for the Butterfly Strategy
An options fly, also known as a butterfly spread, is an options strategy that involves combining multiple options positions with different strike prices to profit from a neutral outlook on the underlying asset. Here's a summary of the key points:
Combination strategy: A butterfly spread involves buying and selling call options (call butterfly) or put options (put butterfly) with different strike prices.
Three strike prices: The strategy involves options with three different strike prices: one lower (A), one at-the-money (B), and one higher (C).
Four options contracts: The investor buys one option with strike price A, sells two options with strike price B, and buys one option with strike price C (all with the same expiration date).
Neutral outlook: The strategy is used when the investor expects the underlying asset's price to remain near strike price B until the options expire.
Limited risk: Both the maximum profit and maximum loss are limited, making this strategy relatively low risk.
Maximum profit: The maximum profit occurs when the underlying asset's price is equal to strike price B at expiration. The profit is the difference between the strike prices (B-A or C-B) minus the net premium paid.
Maximum loss: The maximum loss is limited to the net premium paid for the options.
Break-even points: The strategy becomes profitable when the asset's price is between the two break-even points, which are strike price A plus the net premium paid and strike price C minus the net premium paid.
Time decay: Time decay (Theta) works in favor of the butterfly spread, as the options sold at strike price B lose value faster than the options bought at strike prices A and C.
What is the maximum loss for a butterfly spread?
The maximum loss is theoretically unlimited.
The maximum loss is limited to the net premium paid for the options.
The maximum loss is limited to price difference at the time of expiration.