What is a 'Butterfly Spread'
A butterfly spread is a neutral option strategy combining bull and bear spreads. Butterfly spreads use four option contracts with the same expiration but three different strike prices to create a range of prices the strategy can profit from. The trader sells two option contracts at the middle strike price and buys one option contract at a lower strike price and one option contract at a higher strike price. Both puts and calls can be used for a butterfly spread.
BREAKING DOWN 'Butterfly Spread'
Butterfly spreads have limited risk, and the maximum losses that occur are the cost of your original investment. The highest return you can earn occurs when the price of the underlying asset is exactly at the strike price of the middle options. Option trades of this type are structured to have a high chances of earning a profit, albeit a small profit. A long position in a butterfly spread will earn profit if the future volatility of the underlying stock price is lower than the implied volatility. A short position in a butterfly spread will earn a profit when the future volatility of the underlying stock price is higher than the implied volatility.
Call Option Butterfly Spread Characteristics
By selling short two call options at a given strike price, and buying one call option at an upper and one at a lower strike price (often called the wings of the butterfly), an investor is in a position to earn a profit if the underlying asset achieves a certain price point at expiration. A critical step in constructing a proper butterfly spread is that the wings of the butterfly must be equidistant from the middle strike price. Thus, if an investor short sells two options on an underlying asset at a strike price of $60, he must purchase one call option each at the $55 and $65 strike prices.
In this scenario, an investor would make the maximum profit if the underlying asset is priced at $60 at expiration. If the underlying asset is below $55 at expiration, the investor would realize his maximum loss, which would be the net price of buying the two wing call options plus the proceeds of selling the two middle strike options. The same occurs if the underlying asset is priced at $65 or above at expiration.
If the underlying asset is priced between $55 and $65, a loss or profit may occur. The amount of premium paid to enter the position is key. Assume that it costs $2.50 to enter into the position. Based on that, if the underlying asset is priced anywhere below $60 minus $2.50, the position would experience a loss. The same holds true if the underlying asset were priced at $60 plus $2.50 at expiration. In this scenario, the position would profit if the underlying asset is priced anywhere between $57.50 and $62.50 at expiration.