SteadyOptions is an options trading forum where you can find solutions from top options traders. Join Us!

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:

Join Us
 

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

Subscribe

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Ready to Invest? Here's How to Get Started with Online Trading

    I am struggling with making the decision to get started.  How much money do I need to be efficient and effective following your instructions?  What software and where to find it?  I could really benefit from extra income but I am also in a position where I can't really afford to lose much so there is some doubt/fear.  But, your information and attitude felt right to me so I reached out.

    By Karl Domm,

    • 0 comments
    • 114 views
  • The Importance  of Proactive Hedging in Options Trading

    Investing in the stock market can be a daunting task for even the most experienced investors. With the constant fluctuations and volatility of the market, it can be difficult to predict the future direction of the market. This is where options trading comes into play.

    By Karl Domm,

    • 0 comments
    • 187 views
  • The Silent Bank Run

    Long before Silicon Valley Bank failed, the banking sector was experiencing a silent bank run. Unlike the Great Depression, where lines of people clamoring for their money were blocks long, this silent bank run, as its name portends, has been out of sight until recently. There are a couple of reasons for this. 

    By Michael Lebowitz,

    • 0 comments
    • 154 views
  • High Probability Strategy: A Holy Grail of Options Trading?

    A lot of options traders consider a 90% probability strategy a Holy Grail of trading. After all, if you can win 90% of the time, you should be able to grow your account very quickly, right? Well, not only this is not necessarily true, but in fact, a Winning Ratio alone tells you nothing about your chances to be profitable.

    By Kim,

    • 0 comments
    • 140 views
  • The 10 Best Options Trading Books

    Options trading can be challenging. I look at it as a journey, a long term investment, which is no different that graduating from University. And like University, you need to do a lot of reading, along with a lot of practicing. Fortunately, there are a lot of books out there that can be of tremendous help in this journey.

    By Kim,

    • 0 comments
    • 255 views
  • OptionNET Explorer (ONE) Software

    OptionNET Explorer (ONE) is a complete options trading and analysis software platform that enables the user to backtest complex options trading strategies, analyze their results and monitor them in real-time, all from within a single, user friendly environment. 

    By Kim,

    • 0 comments
    • 252 views
  • What Happened to SFO Magazine (SFOMag)? Stocks, Options and Futures Magazine

    Remember SFO Magazine? Traders like Jack Schwager and Brett Steenbarger used to write for the publication before its swift shutdown in 2012. What happened. SFO (Stocks, Futures, and Options) magazine was a monthly financial magazine focused on trading and investing in stocks, futures, and options markets.

    By Pat Crawley,

    • 0 comments
    • 867 views
  • How to Use the Finest Covered Call Strategy

    Investing in the stock market can be a great way to grow your wealth over time. However, it can also be a volatile and unpredictable place, with sudden swings in stock prices causing anxiety for even the most experienced investors. This is where the covered call strategy comes in - a popular options trading strategy that can help manage portfolio volatility.

    By Kim,

    • 0 comments
    • 782 views
  • Put/Call Parity

    Put/call parity is a crucial concept in options trading that establishes the basics of option pricing. The formula, introduced in 1969, came years before the seminal Black-Scholes pricing model. As such, it was one of the first formulations of quantitative option pricing and served as the foundation for future pioneers like Black, Merton, and Scholes.

    By Pat Crawley,

    • 0 comments
    • 412 views
  • What Are Cash-Settled Options?

    Options are finite, wasting assets. They have a shelf-life, and they cease to exist after their expiration. So when that expiration date comes, there needs to be a mechanism in place to ensure that both sides of an option contract hold up their side of the bargain.

    By Pat Crawley,

    • 0 comments
    • 944 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