Butterfly Spreads Option Trading | Capitalinvestopedia

Butterfly spread is an options trading strategy that involves using multiple options contracts with the same expiration date but different strike prices to profit from a specific range of underlying asset prices. It is a limited-risk, limited-reward strategy that can be used in various market conditions, including when an investor expects minimal price movement or increased price volatility.

A butterfly spread can be constructed using either call options or put options, and it can be either a long butterfly spread or a short butterfly spread:

1. Long Call Butterfly Spread:
   • To create a long call butterfly spread, you buy one lower strike call option, sell two middle strike call options, and buy one higher strike call option.
   • All options should have the same expiration date.
   • The middle strike price should be equidistant from the lower and higher strike prices.
   • This strategy profits from minimal price movement in the underlying asset, as it benefits from the price staying near the middle strike price.
   • Maximum profit occurs when the underlying asset closes at the middle strike price at expiration.
   • The maximum loss is limited to the initial cost of creating the spread.
2. Long Put Butterfly Spread:
   • To create a long put butterfly spread, you buy one lower strike put option, sell two middle strike put options, and buy one higher strike put option.
   • All options should have the same expiration date.
   • The middle strike price should be equidistant from the lower and higher strike prices.
   • Like the long call butterfly, this strategy profits from minimal price movement in the underlying asset, as it benefits from the price staying near the middle strike price.
   • Maximum profit occurs when the underlying asset closes at the middle strike price at expiration.
   • The maximum loss is limited to the initial cost of creating the spread.
3. Short Call Butterfly Spread:
   • A short-call butterfly spread is essentially the reverse of a long-call butterfly spread. You sell one lower strike call option, buy two middle strike call options, and sell one higher strike call option.
   • This strategy generates credit initially, but it has limited profit potential and involves unlimited risk if the underlying asset’s price moves significantly in one direction.
4. Short Put Butterfly Spread:
   • A short put butterfly spread is essentially the reverse of a long put butterfly spread. You sell one lower strike put option, buy two middle strike put options, and sell one higher strike put option.
   • Similar to the short call butterfly spread, this strategy generates a credit initially but has limited profit potential and involves unlimited risk if the underlying asset’s price moves significantly in one direction.

The goal of a butterfly spread is to benefit from a narrow range of price movement in the underlying asset while limiting both potential profits and potential losses. Traders often use butterfly spreads when they anticipate low volatility in the near term, as they profit the most when the underlying asset remains close to the middle strike price. However, the commissions and fees associated with multiple options contracts can eat into potential profits, so it’s essential to consider these costs when implementing this strategy. Learn and trade with Capitalinvestopedia.