Loading the player...

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. The trader sells two option contracts at the middle strike price, buys one option contract at a lower strike price, and buys another option contract at a higher strike price. Puts or calls can be used for a butterfly spread. The strategy is used when the trader believes the price of the underlying asset will not deviate much from the current price.

Breaking Down the 'Butterfly Spread'

Butterfly spreads have limited risk, and the maximum loss is the net premium paid to take the position. Profit is also capped.

Long Call Butterfly Spread Example

By selling short two call options at a given strike price, and buying one call option at an upper and 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 are equidistant from the middle strike price. Thus, if an investor short sells two options on an underlying asset at a strike price of $60, the upper and lower options should have strike prices equal dollar amounts above and below $60. At $55 and $65, for example, as these strikes are both $5 away from $60.

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, or above $65, the investor would realize their maximum loss, which would be the cost of buying the two wing call options plus the proceeds of selling the two middle strike options.

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.

This scenario does not include the cost of commissions, which can add up when taking multiple options positions. 

Long Call Butterfly Spread

There are several different kinds of butterfly spreads. The long butterfly call spread is created by buying one in-the-money call option with a low strike price, writing two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. A net debit is created when entering the trade. This is the scenario above. 

Short Call Butterfly Spread

The short butterfly spread is created by selling one in-the-money call option with a low strike price, buying two at-the-money call options, and selling an out-of-the-money call option at a higher strike price. A net credit is created when entering the position. This positions profits if the price of the underlying moves toward the upper or lower strike price.

Long Put Butterfly Spread

The long put butterfly spread is created by buying one put with a lower strike price, selling two at-the-money puts, and buying a put with a higher strike price. A net debit is created when entering the position. Like the long call butterfly, this position has maximum profit when the underlying stays at strike price of the middle options. 

Short Put Butterfly Spread

The short put butterfly spread is created by writing one out-of-the-money put option with a low strike price, buying two at-the-money puts, and writing an in-the-money put option at a higher strike price. This strategy profits if the underlying moves toward the upper or lower strike prices.

Iron Butterfly Spread

The iron butterfly spread is created by buying an out-of-the-money put option with a lower strike price, writing an at-the-money put option with a middle strike price, writing an at-the-money call option with a middle strike price, and buying an out-of-the-money call option with a higher strike price. The result is a trade with a net credit that's better suited for lower volatility scenarios. The maximum profit occurs if the underlying stays at the middle strike price. 

Reverse Iron Butterfly Spread

The reverse iron butterfly spread is created by writing an out-of-the-money put option at a lower strike price, buying an at-the-money put option at a middle strike price, buying an at-the-money call option at a middle strike price, and writing an out-of-the-money call option at a higher strike price. This creates a net debit trade that's better suited for high-volatility scenarios. Profit occurs when the price of the underlying moves toward the upper or lower strike prices.

RELATED TERMS
  1. Iron Butterfly

    An iron butterfly is a options strategy created with four options ...
  2. Condor Spread

    A condor spread is a non-directional options strategy that seeks ...
  3. Bull Spread

    A bull spread is a bullish options strategy using either two ...
  4. Vertical Spread

    A vertical spread strategy uses purchases and sales of the same ...
  5. Long Leg

    The part of an option spread strategy that involves buying an ...
  6. Short Leg

    Any contract in an option spread in which an individual holds ...
Related Articles
  1. Trading

    The Butterfly Spread

    A butterfly spread is a neutral options strategy with both limited risk and limited profit potential. The strategy involves four options contracts with the same expiration month but with three ...
  2. Trading

    Advanced Option Trading: The Modified Butterfly Spread

    This strategy allows traders to craft a position with unique risk/reward characteristics.
  3. Trading

    Using Options To Pay Off Debt

    We tell you about four option strategies that could provide a way to pay off your debt.
  4. Trading

    Explaining Credit Spread

    A credit spread has two different meanings, one referring to bonds, the other to options.
  5. Investing

    Globalization and the Butterfly Effect

    Discover how the butterfly effect applies to global capital markets and witness how chaos theory can describe market volatility.
  6. Trading

    What To Do When Your Options Trade Goes Awry

    Check out some repair strategies to help boost the profit potential of a losing position.
  7. Trading

    Which Vertical Option Spread Should You Use?

    Knowing which option spread strategy to use in different market conditions can significantly improve your odds of success in options trading.
  8. Trading

    The Dangerous Lure Of Cheap Out Of The Money Options

    Betting on a big price move with cheap out of the money options can be profitable, but understand the risks and alternatives before doing it.
  9. Trading

    What Is A Bull Put Spread?

    Investopedia explains: A bull put spread is a variation of the popular put writing strategy, in which an options investor writes a put on a stock to collect premium income and perhaps buy the ...
RELATED FAQS
  1. How does the term 'in the money' describe the moneyness of an option?

    Find out what in the money means about the moneyness of call or put options and what it indicates about the relationship ... Read Answer >>
  2. What happens when a security reaches its strike price?

    Learn more about the moneyness of stock options and what happens when the underlying security's price reaches the option ... Read Answer >>
  3. Can I make money using put options when prices are going up?

    It seems counterintuitive that you would be able to profit from an increase in the price of an underlying asset by using ... Read Answer >>
  4. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  5. When is a call option considered to be "in the money"?

    Learn about call options, their intrinsic values and why a call option is in the money when the underlying stock price is ... Read Answer >>
Hot Definitions
  1. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  2. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  3. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  4. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  5. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
  6. Watchlist

    A watchlist is list of securities being monitored for potential trading or investing opportunities.
Trading Center