Options are derivatives contracts with values determined by the price of their underlying stock. Options strategies can be used in a number of different ways: speculative trading, applying leverage or hedging existing stock positions. Some of the most intricate trading techniques use multiple options to reach the desired goal. One of these techniques is the butterfly spread, which is a combination of a bull and a bear trade used to reach a market-neutral position.
What Is a Butterfly Spread?
When markets are volatile, experienced investors may seek to profit by adopting a complex option strategy like butterfly spreads. By using these strategies, investors can potentially profit from both upward and downward swings in the market as long as the volatility remains present. The direction doesn’t matter, just that the price moves one way or another.
Options strategies like butterfly spreads can also work if markets are flat. A butterfly spread can also be used to potentially earn a return when a stock doesn’t move at all, which makes it a convenient options strategy for sophisticated investors. And it is a fairly sophisticated strategy — you’ll need to manage four options contracts at once and have the ability to write options in your brokerage account.
How Does a Butterfly Spread Work?
A butterfly spread involves four options at three different strike prices. The goal of such a trade can be different depending on your outlook: to potentially profit from volatility or from a lack of volatility, depending on if the trader is long or short the butterfly strategy One of the benefits of a butterfly spread strategy is the risk level. Outsized profits aren’t typically the goal of butterfly spreads, but limited profit also means limited risk — losses are capped at the cost of opening the position (premium plus fees).
The four options can be puts, calls or both, depending on the parameters and goals of the trade. The long butterfly is formed by writing two at-the-money (ATM) options and buying two additional options with strike prices equidistant to the strike price of the written options. For example, if the written options have a strike price of $20, you’d then buy an option with a $10 strike and a $30 strike.
Types of Butterfly Spreads
Butterfly spreads are diverse options strategies that can be used with a wide range of contracts. Below are a few of the most commonly applied iterations of this strategy.
1. Long Put Butterfly Spread
A long put butterfly spread is built with two ATM put options, an in-the-money (ITM) put option and an out-of-the-money (OTM) put option. Maximum profit may be achieved if the stock price remains the same, and maximum loss occurs if the stock price is outside the range between the ITM and OTM options. For example, if stock AAA is trading at $20, you’d write two $20 put options and then buy a $15 put option and a $25 put option. Max profit occurs if the stock is $20 at the expiration of the options, and max loss occurs if the stock price is $14 or $26 at expiration.
2. Short Put Butterfly Spread
Short put butterfly spreads are the opposite of the long put variation. Instead of writing two ATM puts, you’d buy two ATM puts and write ITM and OTM puts. Let’s use the same example as above, but instead of buying the $15 and $25 puts of AAA stock, you’d sell them and buy two $20 puts. This trade reaches maximum gain if the stock price closes above $25 or below $15, and max loss occurs if the price stays static.
3. Long Call Butterfly Spread
Long call butterfly spreads use calls instead of puts to profit from a lack of volatility. To use a long call butterfly spread, you’d write two ATM calls and buy an ITM and OTM call equally apart from the current stock price. Like the example above, if the stock price stays flat until expiration, the long call butterfly spread hits maximum profit. If the stock price rises or falls beyond the strike price of the two other calls, max loss occurs.
4. Short Call Butterfly Spread
Again, similar to the short put version, the short call butterfly spread hits maximum profit potential during volatile trading periods. To execute this trade, you’d buy the two ATM calls and sell the ITM and OTM calls. If AAA stock is trading at $20, the trade loss max is hit if the price stays at $20. If the ITM and OTM calls were bought with $18 and $22 strike prices this time, that’s the range outside of which maximum profit is achieved and the full net credit is kept less any fees.
4. Short Iron Butterfly Spread
A short iron butterfly is a combination of put and call options. Potential profits are limited with iron butterflies, but the risk tends to be lower. To open an iron butterfly spread, you’d buy an OTM put and an OTM call, then sell an ATM put and an ATM call. If the underlying stock price remains unchanged, the premiums of the ATM put and call options are collected as profit. Max loss occurs if the stock price is outside the range of the OTM put and call options.
5. Long Iron Butterfly Spread
The four option purchases in the long iron butterfly spread go like this: Buy an ATM put and ATM call, then sell an OTM put and OTM call. Unlike the short iron butterfly, this trade will cost money to open. Volatility will create profit with this trade; if the price moves to the OTM put or OTM call strike prices, maximum profit is achieved. Max loss occurs when the price remains at the ATM mark and the investor eats the premium (plus commissions) of opening the position.
Potential Advantages of Using a Butterfly Spread
- Limited downside: Butterfly spreads are constructed so that losses cannot exceed the cost of opening the position.
- Works in volatile and flat markets: You can build a specific butterfly spread trade to potential profit from any type of market.
- Multiple varieties: From long calls to short puts, butterfly spreads can be constructed from different types of options and upside/downside can be known upon creating the strategy based on the makeup of the four options used.
Things to Consider When Using a Butterly Spread
Market-neutral trading strategies can be effective, but they’ll also always limit a trader’s potential profits. If you’re investing in AAA stock and it doubles in six months, no type of butterfly spread will outperform simply owning the stock in that scenario.
When using butterfly spreads, also consider your risk tolerance and trading goals. Are you expecting volatile markets or moderate movement? Do you want to increase the probability of profit or narrow the range for a bigger potential gain? You’ll need to ask yourself a few important questions before opening any type of butterfly spread trade.
Additionally, using complex strategies like butterfly spreads can complicate the risks of the trade. For example, transaction costs can be quite high since multiple contracts are being traded, plus you need to monitor the liquidity restraints of each since liquidity varies from contract to contract, even with the same underlying stock.
Butterfly Spreads Limit Risk But Also Upside
Butterfly spreads are market-neutral options strategies with wide ranges of profit opportunities. One of the biggest benefits of these trades can be their flexibility — certain butterfly spreads work in volatile markets, while others work in steady markets.
It’s important to remember that butterfly spreads may limit profit opportunities as well as risk. For example, if a stock drops 50%, selling the shares short with moderate fees and borrowing costs would likely result in a more profitable trade than utilizing a butterfly spread on the same stock. You’d potentially make far less with a butterfly spread even if maximum profit is attained since the profit potential is capped within a specific range. Like any trading strategy, butterfly spreads have their pros and cons so be sure to consider them before trading.
Frequently Asked Questions
When to consider a butterfly spread?
Butterfly spreads are generally best used when traders want to open a market-neutral position.
Should you let a butterfly spread expire?
The decision to let a butterfly spread expire depends on the parameters of the trade and the goal of the investor. Please note, letting options go into expiration can open the investor to additional risks including but not limited to exercise or assignment risks, margin calls, and other requirements.
How do you manage butterfly spread?
Because four options are used to open a butterfly spread, different legs of the trade can be closed at different times to help manage risk. If this happens, the initial risk profile may change as well. There are other ways to manage an open butterfly spread, be sure to review the different options before entering a trade. Managing this strategy is complex and requires careful thought on how best to manage it to your individual situation.
About Dan Schmidt
Dan Schmidt is a finance writer passionate about helping readers understand how assets and markets work. He has over six years of writing experience, focused on stocks. His work has been published by Vanguard, Capital One, PenFed Credit Union, MarketBeat, and Fora Financial. Dan lives in Bucks County, PA with his wife and enjoys summers at Citizens Bank Park cheering on the Phillies.