What are Butterfly Spreads?

A butterfly spread is a neutral option spread trading strategy that can be used to trade both puts and calls. A butterfly spread is unique to options trading. A butterfly spread options trade is done when the trader places four option trades with three different strike prices, in order to give the trade the opportunity to benefit from any one of the strike prices. This can be pictured appropriately by looking at the trades in the context of a butterfly, where the lowest and highest strike prices form the wings of a butterfly and the middle strike prices form the body of the butterfly

As indicated previously, the butterfly spread can be used to trade puts and calls. For a call option butterfly spread trade, the trader buys an option call at a strike price, then sells two option calls at a higher strike price, and finally, buying another call option at an even higher strike price. In other words:

–          Long 1 XY 120 Call (butterfly 3)

–          (Short 1 XY 110 Call) X 2 (butterfly 2)

–          Long 1 XY 100 Call (butterfly 1)

For a put option butterfly spread trade, the trader buys an option call at a strike price, then sells two call options at a lower strike price, and buys another call option at an even lower price.

–          Long 1 XY 120 Call (butterfly 1)

–          (Short 1 XY 110 Call) X 2 (butterfly 2)

–          Long 1 XY 100 Call (butterfly 3)

The essence of this trade is to create a potential profit range within which the prices have a chance of experiencing a profit over a period of time. The butterfly is a minimum risk trade; the trader can only lose his initial investment on the trade plus any commissions paid on the trade.

Maximum profits are made when the price hovers around the middle strike price.

Trade Example

Let us take an example using our stock XY, which is trading at $75.28. The butterfly spread trade sets up as follows:

–          Buy 1 XY 72 Call @ $6.10 per share or $610.00 (wing)

–          Sell 2 XY 75 Call @ $4.10 per share or $820.00 (butterfly body)

–         Buy 1 XY 78 Call @ $2.60 per share or $260.00 (wing)

The net profit from this trade is the difference between the 2 long calls and the 2 short calls, which is (610 + 260) – 820 = $50 ($0.50 per share).

Breakeven points

The breakeven points from this trade are seen as follows:

Breakeven point 1 = Lowest strike price + net profit = 72 + 0.50 = $72.50

Breakeven point 2 = Highest strike price – net profit = 78 – 0.50 = $77.50

Maximum Profit

As indicated earlier, maximum profits are obtained when price is at the middle strike price of $75 on expiration. The true profit will therefore be:

Middle strike price (75) – lower strike price (72) – net debit on trade (0.50) = $2.50 per share

Maximum Loss

Maximum loss occurs if the price of stock XY is below the lowest strike price or above the highest strike price. In each case, the loss is restricted to the net debit on the trade (0.50 per share or $50) plus any commissions paid.

 

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