What is a Butterfly Spread?

What is a Butterfly Spread?

In finance, butterfly is a limited risk, non-directional options strategy which is designed to have had a  high probability of earning a limited profit when the future volatility of the underlying asset is expected to be lower or higher than the implied volatility when long or short respectively.

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A butterfly spread is an options strategy, which is neutral and has limited risk. It is made by combining bull spreads and bear spreads. The holder of butterfly option can combine four options contracts which have the same expiry at three strike price points. This, it creates a perfect range of prices and building profit. While a trader buys two option contracts, one of them is high at the strike price, and another one is lower. Simultaneously, two option contracts are sold, which have a strike price between high and low, but the condition is to keep the difference between high and low equal to the middle. One can use both calls and puts in Butterfly spread option. The critical aspects of this option involve buying or selling call/put potions,

What are different Variations of Butterfly Spread?

1) Long Butterfly Option

This strategy involves having a neutral or bond market outlook. The price of the underlying asset is going to move a little only since butterfly spreads are tight. They do not allow much movement in price and hence are not suited for trading with high probability.  A long butterfly spread is a limited risk and profit strategy. It’s quite difficult and rare to reach maximum profit because the underlying has to be at the strike of two short positions exactly. Maximum loss usually occurs when the underlying is outside the strike of two long positions.

2) Short Butterfly Option

Short butterfly option is quite a unique strategy since it’s a low probability of nature and very low-profit potential. It’s not recommended strategy compared to other approaches that work similarly. Trade in a short butterfly option is expected to make a significant movement in the short future. The price won’t move as far as in other strategies, but it will move. Thus, this butterfly spread comes useful for high probability option strategies. But in case the underlying asset makes a more significant move than expected, the investor loses any chance of making money, because of the limited profit potential. It is a well-defined risk and profit strategy. It reaches maximum profit when the underlying asset moves a little further than any one of the strikes of short options. The loss occurs when the underlying price is precisely at the strike of two long positions. Maximum loss doesn’t happen too often, because it is a tiny spot.

3) Long Iron Butterfly

There is another variation, called the Long iron Butterfly. An iron butterfly is quite similar to standard butterfly as the payoff is exactly the same, but the set up is a little different.  The maximum profit and loss in this strategy are calculated quite differently. This strategy is established for net debt, and there are limited potential profit and maximum risk. The significant difference here is the maximum benefit, which is the difference between the lower and middle strike price, less the net debit paid. It reaches maximum benefit when the stock price is above the highest strike price and below the lowest strike price. The maximum risk includes the net cost of the position comprising of commissions.

Concluding the butterfly spread strategy, though it has its own set of variations, all of them use four options and three different strike prices. Herein, the upper and lower strike prices are equidistant from the middle strike price, and all of them have a maximum profit and maximum loss ratio.