SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Butterfly Spread Strategy - The Basics


A butterfly spread is an option strategy combining bull spread and bear spread. Butterfly spreads use four option contracts with the same expiration but three different strike prices. There are few variations of the butterfly spreads, using different combinations of puts and calls. Butterfly spreads can be directional or neutral.

This article describes the different variations of the butterfly spread.

Long Butterfly Spread

This is a limited profit, limited risk options strategy. There are 3 strikes involved in a butterfly spread and it can be constructed using calls or puts. It is entered when the trader believes that the underlying will not move much by expiration.

Construction:

  • Buy 1 ITM Call
  • Sell 2 ATM Calls
  • Buy 1 OTM Call

OR

  • Buy 1 ITM Put
  • Sell 2 ATM Puts
  • Buy 1 OTM Put

P/L chart:

image.png


There is some confusion regarding terminology, but most sources and brokers agree that "Buy a butterfly" or Long Butterfly means selling the body strikes and buying the wings. Here is a screenshot from Interactive Brokers:

image.png

Please note that Butterfly spread is purchased for a debit. In order to make a profit, you would aim to sell it for more than you paid for it (exactly like a stock). There is no margin requirement to buy a butterfly, except for the debit paid.

Maximum profit for the long butterfly spread is achieved when the underlying price is exactly at the short strikes at expiration. 

Long Iron Butterfly Spread

The same trade can be constructed using combination of calls and puts.

Construction:

  • Buy 1 OTM Put
  • Sell 1 ATM Put
  • Sell 1 ATM Call
  • Buy 1 OTM Call

P/L chart is identical to the long butterfly spread:

image.png


Please note that Iron Butterfly spread is purchased for a credit. In order to make a profit, you would aim to buy it back for less debit than the credit you got (exactly like a short stock). There is margin requirement equal to the distance between the short and the long strikes. Buying Iron Butterfly is basically selling ATM straddle and hedging it with OTM strangle.

Maximum profit for the long butterfly spread is achieved when the underlying price is exactly at the short strikes at expiration. 

Example:

With TLT trading around $112, we could enter the following butterfly, using calls only:

  • Buy 1 December 21 107 Put
  • Sell 2 December 21 112 Put
  • Buy 1 December 21 117 Put

This is a $5 wide butterfly, and the debit would be around $2.15, The maximum price at expiration is $5, so the profit potential is $2.85 or 132%:
 

image.png

Same trade could be constructed as an Iron Butterfly, using combination of puts and calls:

  • Buy 1 December 21 107 Put
  • Sell 1 December 21 112 Put
  • Sell 1 December 21 112 Call
  • Buy 1 December 21 117 Call

This is a $5 wide butterfly, and the credit would be around $2.85. The margin requirement is 5.00-2.85=2.15, exactly the same as the debit of the put butterfly:


image.png


As you can see, the P/L chart and the profit potential of the butterfly and iron butterfly are very similar when same strikes are used.

Short or Reverse Butterfly Spread

This is a limited profit, limited risk options strategy. There are 3  strike prices  involved in a butterfly spread and it can be constructed using calls or puts. It is entered when the trader believes that the underlying  will move by expiration. This is basically an opposite trade to a long butterfly

Construction:

  • Sell 1 ITM Call
  • Buy 2 ATM Calls
  • Sell 1 OTM Call

OR

  • Sell 1 ITM Put
  • Buy 2 ATM Puts
  • Sell 1 OTM Put

P/L chart:

image.png

As we can see, the underlying has to move in order for the trade to make a profit. Maximum profit is achieved when the underlying is above the upper sold strike or below the low sold strike. The trade is executed for a credit.

Once again, to avoid any confusion, here is a screenshot from Interactive Brokers:

image.png

Short or Reverse Iron Butterfly Spread

The same trade can be executed using a combination of puts and calls.

Construction:

  • Sell 1 OTM Put
  • Buy 1 ATM Put
  • Buy 1 ATM Call
  • Sell 1 OTM Call

P/L chart:

image.png

The trade is executed for a debit. Selling Iron Butterfly is basically buying ATM straddle and hedging it with OTM strangle.

Frequently Asked Questions

How the long butterfly spread makes money?      

The first way is the time decay. The idea is that ATM options will lose value faster than the ITM and OTM options. The second way a Butterfly Trade makes money is with an decrease in volatility. 
 

What is the risk?

The maximum theoretical risk of the long butterfly is the debit paid. If we hold the trade till the expiration and the stock trades outside of the P/L zone, the trade will lose 100%. As a general rule of thumb, the average loser size should not exceed the average winner size. 
 

Calls vs. puts

In general, there should not be a significant difference between calendar spread using calls or puts. The P/L graph is usually very similar. When opening a delta negative fly, I tend to open it with puts. The reason is that OTM options tend to be slightly more liquid, and there is no assignment risk.
 

Can I be assigned on my short options?

If your short options become deep ITM, you can be assigned. Assignment risk becomes real only if there is very little time value left on the short options. There is no assignment risk on indexes like SPX or RUT, but stocks like SPY or IWM (or individual stocks) do have assignment risk. Assignment by itself is not a bad thing - unless it causes a margin call and forced liquidation. Usually you are 100% covered - each dollar you lose in the stock you gain in the options.
 

Directional or non-directional?

At SteadyOptions, we trade non-directional trading. So in most cases, we will want to be as delta neutral as possible. However, in some cases we will structure the trade slightly directional if we have a strong bias about the underlying.

Summary

The butterfly spread has few variations, but they all have few things in common:

  • Three equidistant strikes involved.
  • Same expiration.
  • Limited profit, limited loss.

The following table summarizes the most important features of the different variations of the Butterfly Spread strategy.

image.png
 

If you want to learn more how to use the butterfly spread and other profitable strategies and increase your odds:

Start Your Free Trial
 

Related articles:

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Probability vs. Certainty Trap

    We all would like all our trades to be winners, but we know this is not possible. We know some of the trades will be losers. Many traders think that if a trade has lost money, it was a bad trade. They try to identify what errors they made that lead to losses. Why? "Because I lost money! So surely I have made a mistake somewhere?”

    By Kim,

    • 2 comments
    • 6,234 views
  • How To Choose The Right Platform For Your Stock Trading

    The interest in stock trading has increased due to its higher returns and profit potentials. Like the many traders available, there are numerous approaches and platforms to set your trading environment. Online trading platforms provide adequate resources and tools for their clients' trading success.

    By Kim,

    • 0 comments
    • 1,303 views
  • How To Approach Passive Investing

    Passive investing refers to an investment technique that seeks to increase returns by limiting purchasing and selling. One of the most popular passive investment strategies is index investing, this means that a group of investors buy a representative benchmark, and keep hold of this over a long period.

    By Kim,

    • 0 comments
    • 1,284 views
  • How Anchor Survived the 2020 Crash

    We are often asked how the Anchor strategy performed during the market crash of 2020. The monthly performance can be seen on the performance page, but it shows the End of Month values and doesn't tell the whole picture. This article will shows a detailed analysis of the Anchor portfolio during the crash.

    By Kim,

    • 2 comments
    • 2,902 views
  • Lumpy Dividends and Options

    Dividend payments, like oatmeal, may be smooth or lumpy. Smooth dividends are predictable, usually once per quarter. It is easy for options traders to believe these dividends are guaranteed, because they usually continue uninterrupted quarter after quarter. This also makes it easy to predict total return over a longer time span.

    By Michael C. Thomsett,

    • 0 comments
    • 3,152 views
  • Got Crypto? Here's How to Use It

    Cryptocurrencies are fast becoming an accepted personal and corporate finance method - much to the chagrin of centralized banks and established financial institutions. The reasons are numerous, but in a nutshell, the decentralization of massive amounts of currency poses a threat to their systems.

    By Kim,

    • 0 comments
    • 1,902 views
  • Option Payoff Probability

    Many options analyses focus on profit, loss and breakeven. These show what occurs on expiration day, assuming the option remains open to that point. But this is not realistic. Most options are closed or exercised before expiration, is calculation of how probable a payoff is going to be, how likely the loss, or the exact neutral outcome (breakeven), are all unrealistic.

    By Michael C. Thomsett,

    • 0 comments
    • 1,746 views
  • How to Open Your Own Trading Office

    Are you ready to break out on your own? Have you been trading for a company for years making tons of money for yourself and others? Are you ready to take home a bigger piece of the pie? If you answered “yes” to these questions then you have the skills necessary to take your passion for trading to the next level.

    By Kim,

    • 0 comments
    • 2,031 views
  • How To Create Your Own Indexed Annuity

    Indexed annuities are a life insurance company product sold by insurance brokers for a commission that is based on the amount deposited into the contract. Contract performance is linked to popular indexes like S&P 500, and early withdrawal penalties typically apply for the first 7-10 years if withdrawals greater than 10% of the contract value are taken each year.

    By Jesse,

    • 0 comments
    • 2,705 views
  • Q&A with Mental Game Coach Jared Tendler

    QUESTION: Thank you for taking the time to participate in a Q & A session with Steady Option. Let’s start with an introduction and a little bit of background on who you are and how you got here.

    By Jared Tendler,

    • 0 comments
    • 2,593 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido