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.
ExplanationA 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
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