Fun fact – did you know the top butterfly flight speed is 12 miles per hour? Some moths can even fly 25 miles per hour! How does your trading compare? Don’t feel bad if your trading performance has been less than impressive. So, keep reading for some butterfly spread options that can take your trading from 0 to 60 in no time.
Table of Contents
What Are Butterfly Spread Options?
Butterfly spread options are a fixed risk, non-directional, a.k.a, neutral strategy with capped profit. Which means it’s designed to have a high probability of earning a profit (limited) regardless if you’re long or short. Just like nature gives us a variety of butterflies, we can make our own unique butterfly spread options as well.
Just look at some of the types available below:
- Long Call
- Short Call
- Long Put
- Short Put
- Iron Butterfly
- Reverse Iron
Basics
Butterflies use four option contracts with the same expiration but three different strike prices. It’s a combination of a bull spread and bear spread with 3 strikes. What’s more, it can be constructed using calls or puts.
The different options combined will create different types of butterfly spreads. All are designed to either profit from volatility or low volatility.
So, if you think the underlying stock will not rise or fall much by expiration a long call butterfly spread is a good choice.
How to Construct a Long Call Butterfly Spread
To keep it simple, in order to construct a long call butterfly spread you buy:
- One lower striking In The Money (ITM) call,
- Two At The Money (ATM) calls and
- One higher striking Out Of The Money (OTM) call.
A net debit is taken to enter the trade.
Diagram
In this example below we will:
- Buy one call, strike price A
- Sell two calls, strike price B
- Buy a call, strike price C
The strike prices are all equal distance apart, all options have the same expiration month and the stock price will be at strike B
As you can see in the image above, long call butterflies are a combination of a long call spread and a short call spread. The spreads both converge at strike price B.
In a perfect world, you want the calls with strikes B and C to expire worthless. And you want to capture the intrinsic value of the in-the-money call with strike A.
Butterfly spread options are a relatively low-cost strategy because you’re selling the two options with strike B. Hence why the risk vs. reward can be very tempting. Unfortunately, however, the odds of hitting the sweet spot is fairly low.
If money’s on your mind, constructing your butterfly spread with strike B slightly in or out-of-the-money may make it a bit less expensive. However, this will put a directional bias on the trade.
If strike B is higher than the stock price, this would be considered a bullish trade.
In contrast, if strike B is below the stock price, it is a bearish trade. (But for simplicity’s sake, if bearish, puts would usually be used to construct the spread.)
We kinda have a thing for butterflies around here.
What Are Butterfly Spread Options Break Even Points?
- Here are the break even points for butterfly spread options:
- Upper Break Even Point = Strike Price of Higher Strike Long Call – Net Premium Paid
- Lower Break Even Point = Strike Price of Lower Strike Long Call + Net Premium Paid
- There are two break-even points for this spread:
- Strike A plus the net debit paid
- Strike C minus the net debit paid
When entering a butterfly spread position, there are 2 break-even points for the butterfly spread position. Use the following formula above to calculate the break even points.
Your Maximum Profit Potential
To hit the sweet spot with butterfly spread options, you want the stock price to be exactly at strike B at expiration. Basically, your profit is maximized when the underlying stock price stays the same at expiration. Which means, at this price, only the lower striking call expires in the money.
The formula for calculating maximum profit is given below:
- Maximum Profit = Strike Price of Short Call – Strike Price of Lower Strike Long Call – Net Premium Paid – Commissions Paid
- Maximum Profit Achieved When Price of Underlying = Strike Price of Short Calls
So in this case, potential profit is limited to strike B minus strike A minus the net debit paid
Your Maximum Potential Loss
What I like so much about the long butterfly spread is that risk is limited to your initial debit taken to enter the trade plus commissions.
The formula for calculating maximum loss is given below:
- Max Loss = Net Premium Paid + Commissions Paid
- Max Loss Occurs When Price of Underlying <= Strike Price of Lower Strike Long Call OR Price of Underlying >= Strike Price of Higher Strike Long Call
In this case, potential profit is limited to strike B minus strike A minus the net debit paid.
As Time Goes By
For butterfly spread options, time decay is your friend. Ideally, you want all options except the call with strike A to expire worthless with the stock precisely at strike B.
A Shout out to Implied Volatility
So, if your forecast was correct and the stock price is at or around strike B, you want volatility to decrease. Your main concern is the two options you sold at strike B.
A decrease in implied volatility will cause those near-the-money options to decrease in value, thereby increasing the overall value of the butterfly. In addition, you want the stock price to remain stable around strike B, and a decrease in implied volatility suggests that may be the case.
On the other hand, if your forecast was incorrect and the stock price is approaching or outside of strike A or C, typically you want volatility to increase. This is especially crucial as expiration approaches.
The reason why is an increase in volatility will increase the value of the option you own at the near-the-money strike. While at the same time having less effect on the short options at strike B, therefore increasing the overall value of the butterfly.
Butterfly Spread Options Example
- Suppose American Airlines stock is trading at $40 in June
- An options trader executes a long call butterfly by purchasing a July 30th call for $1100
- Writing two July 40 calls for $400 each and purchasing another July 50 call for $100
- The total cost (net debt) to enter the position is $400
- Also, maximum possible loss
- Upon expiration in July, American Airlines stock is still trading at $40
- The July 40 calls and the July 50 call expire worthless
- However, the July 30 call still has an intrinsic value of $1,000
- When you do the math – subtracting the initial debit of $400, the resulting profit is $600
- This is also the maximum profit attainable
So you may ask “At what point will I incur maximum losses”?. Well, maximum losses will happen when the stock is trading below $30 or above $50.
Firstly, because at $30 all the options expire worthlessly. Secondly, above $50, any “profit” from the two long calls will be neutralized by the “loss” from the two short calls.
In both situations, the butterfly trader suffers maximum loss – $600, which is the initial debit taken to enter the trade.
Note: Even though I used this strategy with reference to stock options, the butterfly spread is equally applicable using ETF options, index options as well as options on futures.
Commissions
As always, commissions can significantly eat away at your profits. This is especially true for trading butterfly spreads as you’re entering multiple positions. Think 4 legs versus 2 in simpler vertical spread strategies.
To be honest, if you’re trading multi-legged options trade frequently, you should shop around. Check out different brokerages and compare their fees. I’m pretty certain E*TRADE charges only $0.50 per contract (+$6.95 per trade) if you trade 30+ in a quarter.
If you’re interested in learning more about E*TRADE, Chris wrote a fantastic, in-depth review. Click here if you want to read more.
Strategies
If you’re looking for strategies similar to the butterfly spread, think low volatility, low risk and limited profit, they are as follows:
- Short Butterfly
- Neutral Calendar Spread (Near-Term Expiration)
- Long Put Butterfly
- Iron Condor
- Wingspreads
Key Takeaways
- They all use four options
- They all use three different strike prices
- The upper and lower strike prices are equal distance from the middle (ATM) strike price.
- Both your profit and risk is capped
- Due to the fact that the sweet spot is narrow and you’re trading three different options in one strategy, butterfly spreads may be better suited for more advanced options traders.
Wrap Up
Is options trading for you? Chances are good that it is. We just need to keep in mind that due to the narrow sweet spot and the fact that you’re trading three different options in one strategy, butterfly spreads may be better suited for more advanced options traders.
If you need more help, take our options trading course.
