An Introduction to the Butterfly Spread
The butterfly spread is a term frequently used by traders to identify certain contracts where they believe supply or demand will be the strongest or weakest. Although the butterfly spread’s four legs are the same in options and futures, there will be some differences in how it is executed.
What Is a Butterfly Spread
An options strategy that combines bull and bear spreads with a set risk and capped reward is known as a butterfly spread. As a market-neutral strategy, these spreads are most profitable if the underlying asset stays the same until the option expires. Either four calls, four puts, or a mix of calls and puts with three strike prices are involved.
How The Butterfly Spread Works
Options and futures traders employ butterfly spreads as a safe strategy. The value of an underlying asset, such as a stock or commodity, determines the value of an option. By a certain expiration or exercise date, buyers can purchase or sell the underlying asset through options contracts.
A butterfly spread blends a bear and a bull spread. Four options contracts with the same expiration date but three distinct strike prices are used in this strategy:
- An increased strike price
- A striking price that is on the money
- A reduced striking price
The gap between the at-the-money options and the options with the higher and lower strike prices is the same. The strike prices of the higher and lower options should be identical to the dollar amounts above and below $60 if the at-the-money options have a strike price of $60. For instance, these strikes are both $5 short of $60 at $55 and $65.
A butterfly spread can be made using calls or puts. Different butterfly spreads may be created by combining the options in different ways; each is intended to either profit from lack or presence of volatility.
A Long Call Butterfly Spread Example
Assume that the stock price of Verizon (VZ) is $60. It won’t move much over the next few months, according to one investor. They decide to use a long call butterfly spread in the hopes of making money if the price remains unchanged. The investor purchases two more calls at $55 and $65 and writes two call options on Verizon with a strike price of $60.
In this scenario, the investor makes the maximum profit if Verizon stock is priced at $60 at expiration. If Verizon is below $55 at expiration, or above $65, the investor realizes their maximum loss, which is the cost of buying the two wing call options (the higher and lower strike) reduced by the proceeds of selling the two middle strike options.
A profit or a loss might happen if the underlying asset is valued between $55 and $65. Assume that the entry fee for the position is $2.50. That means that the trade would lose money if Verizon’s price was any lower than $60 minus $2.50. This is also true if the underlying asset’s expiration price is $60 plus $2.50. In this case, if the price of the underlying asset at expiration is between $57.50 and $62.50, the position makes money.
Bottom Line
Butterfly spreads make use of four option contracts with three distinct strike prices but the same expiration date. a strike price that is higher, one that is at-the-money, and one that is lower. The gap between the at-the-money options and the options with the higher and lower strike prices is the same. There is a maximum profit and a maximum loss for every kind of butterfly.