Butterfly Spread

A butterfly spread has a limited maximum profit and loss when properly set up. It uses four option contracts at three different strike prices.

• Butterfly spreads use four option contracts together
• Three strike prices determine your possible returns
• Long butterflies benefit from smaller price movements
• Short butterflies benefit from larger price movements
• Maximum profit and loss have defined limits
• Trading charges can reduce your final profit

A butterfly spread is an options trading strategy that combines buying and selling options at three different strike prices.

It uses four option contracts with the same expiry date.

You can create a butterfly spread using call options or put options.

There are two main approaches:

• Long butterfly: Generally benefits when the share price stays near the middle strike price
• Short butterfly: Generally benefits when the share price moves away from the middle strike price

A strike price is the price fixed in an options contract. The expiry date is the date when the contract ends.

A butterfly spread helps you set a limit on your possible loss when you create the complete options position correctly.

For example, suppose you expect a share trading at ₹100 to stay near that price for the next few days.

A long butterfly spread can benefit if the share closes near ₹100 on expiry. If the share price moves too far in either direction, you could lose the premium paid.

This means you know your theoretical maximum loss before entering the position. However, brokerage, taxes and settlement-related costs can increase your actual expenses.

A standard long butterfly spread uses three equally spaced strike prices.

Suppose a share is trading at ₹100. A trader creates a long call butterfly using the following positions:

1. Buy one call option at ₹95.
2. Sell two call options at ₹100.
3. Buy one call option at ₹105.

All four options have the same expiry date.

The middle strike is ₹100. This is where the position can earn its maximum profit at expiry.

If the share closes at ₹95 or below, or ₹105 or above, the trader loses the net premium paid.

The actual profit or loss depends on the option premiums and trading costs.

Your maximum profit and loss depend on the strike prices and the premium paid or received.

Consider a trader who creates a long call butterfly with the following details:

Maximum profit = Difference between strikes − Net premium paid

= ₹5 − ₹1 = ₹4 per share

Maximum loss = Net premium paid

= ₹1 per share

The trader breaks even at ₹51 and ₹59 at expiry, before trading costs.

If the share closes at ₹55 on expiry, the maximum theoretical profit is ₹4 per share.

If it closes at ₹50 or below, or ₹60 or above, the trader loses ₹1 per share.

These amounts are calculated per share. Your total result depends on the option contract's lot size. Brokerage, taxes and other charges are excluded.

There are four common types of butterfly spreads. Each uses four option contracts but follows a different buying and selling pattern.

1. Long call butterfly spread

A long call butterfly is generally used when a trader expects the share price to remain near the middle strike until expiry.

It involves:

• Buying one call at the lower strike
• Selling two calls at the middle strike
• Buying one call at the upper strike

For example, the strike prices could be ₹50, ₹55 and ₹60.

The maximum profit occurs if the share closes at ₹55 on expiry.

The maximum loss is the net premium paid to create the position.

2. Short call butterfly spread

A short call butterfly generally benefits when the share price moves significantly away from the middle strike.

It involves:

• Selling one call at the lower strike
• Buying two calls at the middle strike
• Selling one call at the upper strike

For example, the strike prices could be ₹55, ₹60 and ₹65.

If the share closes at ₹55 or below, or ₹65 or above, the position reaches its maximum profit at expiry.

For a standard position created for a net premium received, the maximum profit equals that premium. The maximum loss occurs at the middle strike.

3. Long put butterfly spread

A long put butterfly works similarly to a long call butterfly but uses put options.

It involves:

• Buying one put at the lower strike
• Selling two puts at the middle strike
• Buying one put at the upper strike

For example, the strike prices could be ₹40, ₹45 and ₹50.

The maximum profit occurs if the share closes at ₹45 on expiry.

The maximum loss is the net premium paid.

This strategy generally benefits from price stability rather than a sharp fall.

4. Short put butterfly spread

A short put butterfly generally benefits when the share price moves away from the middle strike.

It involves:

• Selling one put at the lower strike
• Buying two puts at the middle strike
• Selling one put at the upper strike

For example, the strike prices could be ₹40, ₹45 and ₹50.

The position generally reaches its maximum profit if the share closes at ₹40 or below, or ₹50 or above, at expiry.

For a standard position created for a net premium received, the maximum loss occurs at the middle strike.

A butterfly spread helps define potential gains and losses. However, it also has limitations.

Advantages

• Limited loss: The theoretical maximum loss is known when the complete position is created.
• Different market conditions: Long and short butterflies suit different expectations about price movement.
• Call or put options: The strategy can use either type of option.

Disadvantages

• Limited profit: Your earnings cannot exceed the strategy's maximum theoretical profit.
• Price sensitivity: A long butterfly may need the share price to finish near the middle strike.
• Trading costs: Four option contracts can involve multiple transaction charges.
• Execution risk: The prices may change before all positions are completed.

The limited-loss calculation assumes the full strategy is established and managed correctly. Settlement obligations, incomplete execution and other expenses can affect the actual outcome.

A butterfly spread and a long straddle are both options strategies, but they work differently.

A long butterfly generally benefits when the share price stays near the middle strike.

A long straddle generally benefits when the share price moves sharply in either direction. The movement must be large enough to cover the premiums paid.

A butterfly spread uses four option contracts and three strike prices to create a position with defined profit and loss limits. A long butterfly generally benefits when the share price stays near the middle strike at expiry. A short butterfly generally benefits from larger price movements. Neither approach guarantees profit. Your actual result depends on option premiums, price movements, trading charges and settlement requirements. Understanding these factors helps you assess the risks before making any trading decision.