Butterfly Spread

Butterfly Spread

What is a butterfly spread?

A butterfly spread is a market‑neutral options strategy that combines bull and bear spreads to create a position with limited risk and capped profit. It uses four option contracts at three strike prices and can be built with calls or puts. Butterflies are typically used when you expect low volatility or that the underlying will finish near a specific price.

How it works (basic structure)

Standard (long) butterfly with calls:
* Buy 1 call at a lower strike (K1)
* Sell 2 calls at a middle strike (K2)
* Buy 1 call at a higher strike (K3)
Usually K2 − K1 = K3 − K2 (symmetrical wings). The position is entered for a net debit.

Equivalently, you can construct the same payoff with puts (long‑put butterfly). Short butterflies reverse the position (net credit) and profit from large moves away from the middle strike.

Payoff characteristics and key formulas

Let width = K2 − K1 = K3 − K2, and let D be the net premium (debit) paid for a long butterfly.
* Maximum profit (long butterfly) = width − D (occurs if underlying = K2 at expiration)
* Maximum loss (long butterfly) = D (occurs if underlying ≤ K1 or ≥ K3 at expiration)
* Breakeven points (long) = K1 + D and K3 − D

For a short butterfly entered for net credit C:
* Maximum profit = C
* Maximum loss = width − C
* Breakevens = K1 + C and K3 − C

These formulas also apply to put-based butterflies if strikes are set the same.

Common variations

• Long-call butterfly — debit position; profits if price stays near the middle strike.
• Short-call butterfly — credit position; profits from large moves away from the middle strike.
• Long-put butterfly — same payoff as long-call butterfly but built with puts.
• Short-put butterfly — credit strategy that profits from big moves in either direction.
• Iron butterfly — an all‑options (calls+puts) market‑neutral spread: short ATM straddle financed by buying wings (OTM call and OTM put). Typically entered for a net credit and ideal when little movement is expected.
• Reverse iron butterfly — the high‑volatility iron variant, entered for a net debit to profit from big moves.

Example (illustrative)

Suppose a stock currently trades near $170. You set strikes at 165 (K1), 170 (K2), 175 (K3). You:
* Buy 1 165 call
* Sell 2 170 calls
* Buy 1 175 call

If the net premium paid (D) = $1.50 and width = $5:
* Max profit = $5 − $1.50 = $3.50 ($350 per standard contract)
* Max loss = $1.50 ($150 per contract)
* Breakevens = 165 + 1.50 = $166.50 and 175 − 1.50 = $173.50

The strategy makes money when the stock finishes between the breakeven points and maximizes when it closes exactly at the middle strike (170).

Advantages

• Defined, limited risk and known worst‑case loss.
• Low capital outlay relative to directional option positions.
• Effective in range‑bound, low‑volatility markets.
• Flexible: many variations let traders express low or high volatility views.
• Often requires less margin than naked options.

Disadvantages

• Complexity: involves four contracts and precise execution.
• Transaction costs: commissions and slippage can erode profits.
• Low probability of exact maximum profit — requires the underlying to be near the middle strike at expiration.
• Sensitivity to changes in volatility and time decay (different variants respond differently).
• Liquidity: wide bid‑ask spreads or low open interest can make entry/exit expensive.

When to use a butterfly

Use long butterflies when you expect little price movement and want a low‑cost, limited‑risk way to profit if the underlying finishes near a target price. Use short butterflies or reverse iron butterflies when you expect a strong directional move or elevated volatility.

Bottom line

Butterfly spreads are efficient, market‑neutral strategies that cap both risk and reward. They work best when you can reasonably predict a narrow price range for the underlying through expiration. Their defined outcomes and capital efficiency are attractive, but complexity, transaction costs, and the low probability of hitting the exact target price are important tradeoffs to consider.