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Butterfly Spread

Moneyzine Editor
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Moneyzine Editor
2 mins
November 6th, 2024
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Butterfly Spread

Definition

The term butterfly spread refers to a neutral strategy involving a combination of bull and bear spreads using three strike prices. Butterfly spreads are considered a limited profit, limited risk option strategy.

Explanation

A butterfly spread is an option strategy consisting of three different strike prices using a combination of puts or calls. The strategy offers the investor both limited risk as well as reward. Generally, butterfly spreads take the following two forms:

  • Long Butterfly Call: consists of buying one in-the-money call at the lowest strike price, buying one out-of-the-money call at the highest strike price, and writing two at-the-money calls with a strike price that falls in between.

  • Long Butterfly Put: consists of buying one out-of-the-money put at the lowest strike price, buying one in-the-money put at the highest strike price, and writing two at-the-money puts with a strike price that falls in between.

In both of the above scenarios, a net debit is taken by the investor when entering into the trade. This net debit (plus commission) is the maximum loss for a long butterfly spread. The maximum profit for a long butterfly spread occurs when the underlying security's price remains unchanged at expiration.

There are two breakeven points with a butterfly spread, regardless if it is constructed as a put or call:

  • Upper Breakeven Point: Strike Price of Highest Strike Price Option - Net Debit Taken

  • Lower Breakeven Point: Strike Price of Lowest Strike Price Option + Net Debit Taken

Example

Company ABC's common stock is trading at $20.00 per share in January. A trader enters into a long butterfly call, expiring in one month by purchasing a 15 FEB call for $550, writing two 20 FEB calls for $200 each, and buying a 25 FEB call for $50. The initial cash outflow for the trader is:

= -$550 + $200 x 2 - $50= -$550 + $400 - $50, or $200

Assuming the price of Company ABC's stock remains at $20.00 at expiration, the trader would realize their maximum profit, calculated as:

= $500 (value of in-the-money 15 FEB call) - $200 (initial cash outflow, or debit)= $300

Related Terms

  • Calendar Spread (Horizontal Spread)
    The term calendar spread refers to a neutral strategy that involves options with the same underlying stock and strike price but different expiration dates. Calendar spreads are a low risk, low return option strategy that profits from volatility and the passage of time.
    Moneyzine Editor
    Moneyzine Editor
    January 9th, 2024
  • Box Spread
    The term box spread refers to a four-sided option involving a bear and bull spread with identical expiration dates. Box spreads can provide the investor with an arbitrage opportunity, with the trader assuming a nearly riskless position.
    Moneyzine Editor
    Moneyzine Editor
    January 9th, 2024
  • Backspread (Reverse Ratio Spread)
    The term backspread refers to an investment strategy that involves buying more long position options than short positions. Backspreads provide the investor with relatively large exposure to any movement in the underlying security.
    Moneyzine Editor
    Moneyzine Editor
    November 6th, 2024
  • Averaging Down
    The term averaging down refers to an investment strategy that involves buying additional shares of stock at a lower price than originally paid. Averaging down effectively lowers the average price paid per share of stock.
    Moneyzine Editor
    Moneyzine Editor
    November 6th, 2024

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