The Butterfly strategy involves the creation of four options contracts with the same expiration date but three different strike prices, forming a stable range of prices. The trader buys two options contracts: one at a higher strike price and another at a lower strike price. Additionally, the trader sells two options contracts at a strike price positioned between the high and low strike prices, with the middle strike price equalling the difference between the other two. This approach can be applied using either call or put options, as long as all contracts share the same expiration date.
Butterfly strategy example
The Butterfly strategy thrives in non-directional markets, where the trader does not anticipate high volatility. It offers a defined risk while providing an opportunity for profits if the underlying asset’s price stays near the middle strike price at expiration.
An options trader believes that the stock of XYZ Ltd. will trade within a narrow range in the near term. The current price of XYZ Ltd. is Rs. 1000 per share.
How will the trader set up the butterfly spread?
Buy 1 ATM call option
- Buy one call option with a strike price of Rs. 1000 and an expiration date one month away.
- This is the at-the-money (ATM) option.
Sell 2 OTM call options
- Sell two call options with strike prices of Rs. 1050 and Rs. 1100, respectively, expiring in one month.
- These are the out-of-the-money (OTM) options.
Buy 1 further OTM call option
- Buy one call option with a strike price of Rs. 1150, expiring in one month.
- This is the further out-of-the-money (OTM) option.
Now, let us analyse this trade set-up under three different scenarios:
Scenario 1: Price remains within the range (Rs. 1000 - Rs. 1100)
- If the price of XYZ Ltd. stays between Rs. 1000 and Rs. 1100 until expiration, the trader profits.
- The sold options expire worthless, while the purchased options gain value due to their proximity to the ATM option.
- The maximum profit is achieved if the price settles exactly at Rs. 1100 at expiration.
Scenario 2: Price goes above Rs. 1100
- If the price of XYZ Ltd. rises above Rs. 1100, the maximum loss occurs.
- The sold options become in-the-money (ITM).
- This event results in losses that are partially offset by the profits from the purchased options.
- Also, the losses are limited due to the purchased options.
Scenario 3: Price drops below Rs. 1000:
- If the price of XYZ Ltd. falls below Rs. 1000, the maximum loss occurs again.
- In this scenario, the ATM option expires worthless, while the purchased options also lose value.
- However, the losses are limited due to the purchased options.
Types of butterfly option strategy
1. Long call butterfly spread
This strategy involves the following positions:
- Buy one call option at a higher strike price.
- Buy one call option at a lower strike price.
- Sell two call options at a middle strike price.
The maximum profit occurs if the underlying asset’s price is at the middle strike price at expiration. The loss is limited to the premium paid for the options.
2. Long put butterfly spread
This strategy is similar to the long call butterfly but uses put options instead:
- Buy one put option at a higher strike price.
- Buy one put option at a lower strike price.
- Sell two put options at the middle strike price.
The loss is limited to the premium paid for the options contracts, with potential profits arising if the underlying asset’s price stays near the middle strike price.
3. Short call butterfly spread
The short call butterfly is the reverse of the long call butterfly:
- Sell one call option at a higher strike price.
- Sell one call option at a lower strike price.
- Buy two call options at the middle strike price.
This strategy is employed when a trader expects minimal price movement in the underlying asset. The maximum profit is limited to the net premium received from selling the options, while the maximum loss happens if the asset’s price moves significantly beyond the outer strike prices.
4. Short put butterfly spread
The short put butterfly mirrors the short call butterfly, but using put options:
- Sell one put option at a higher strike price.
- Sell one put option at a lower strike price.
- Buy two put options at the middle strike price.
Like the short call butterfly, this strategy benefits from limited price movement. The maximum profit is the net premium received from selling the options, while the maximum loss occurs if the price moves significantly beyond the outer strike prices.
5. Iron butterfly options strategy
An iron butterfly combines a short strangle and a long straddle. It involves:
- Sell one call option at a specific strike price.
- Sell one put option at the same strike price.
- Buy one call option at a higher strike price.
- Buy one put option at a lower strike price.
This strategy is useful when the trader expects limited price movement. It has a limited profit and loss potential, as the maximum gain is capped by the difference between the middle and outer strike prices.
6. Reverse iron butterfly spread
The reverse iron butterfly is the opposite of the iron butterfly:
- Buy one call option at a specific strike price.
- Buy one put option at the same strike price.
- Sell one call option at a higher strike price.
- Sell one put option at a lower strike price.
This strategy is employed when significant price movement in either direction is expected. While it offers unlimited profit potential, it also carries unlimited loss potential if the price moves drastically beyond the outer strike prices.
What are the different types of butterfly trading strategies
Butterfly spreads are a family of options trading strategies. There are several variations of butterfly spreads, each with its unique characteristics and applications. Let us explore some of the common types:
Types
|
Execution
|
Timing
|
Long call butterfly spread
|
- Buy one call optionat a lower strike price
- Sell two call options at a middle strike price, and
- Buy one call option at a higher strike price.
|
Used when the trader expects the price of the underlying asset to remain stable, with a slight bias towards one direction.
|
Long put butterfly spread
|
Similar to the long call butterfly spread, but using put options instead of call options.
|
Used when the trader anticipates minimal movement in the price of the underlying asset.
|
Short call butterfly spread
|
- Sell one call option at a lower strike price
- Buy two call options at a middle strike price, and
- Sell one call option at a higher strike price.
|
Used when the trader expects the price of the underlying asset to remain within a specific range, with no significant movement.
|
Short put butterfly spread
|
Similar to the short call butterfly spread, but using put options instead of call options.
|
Used when the trader anticipates minimal movement in the price of the underlying asset.
|
When is the maximum profit realised
In all the above cases, the maximum profit is achieved if the price of the underlying asset is equal to the middle strike price at expiration.
Conclusion
Butterfly option strategy offers various ways to profit from expected price stability in an underlying asset. Whether it is through long or short call/put butterfly spreads, traders can effectively execute these strategies and maximise their earning potential.
However, as with all forms of futures and options trading, butterfly strategy also comes with risks. Thus, traders must remain cautious and start by practising with small positions. Continuous learning and monitoring the market is the key that can significantly improve the chances of success.
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