0 Butterfly Spread



 
The butterfly spread is a neutral strategy that is a combination of a bull spread and a bear spread. It is a limited profit, limited risk options strategy. There are 3 striking prices involved in a butterfly spread and it can be constructed using calls or puts.

Butterfly Spread Construction
Buy 1 ITM Call
Sell 2 ATM Calls
Buy 1 OTM Call

Long Call Butterfly

Long butterfly spreads are entered when the investor thinks that the underlying stock will not rise or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower striking in-the-money call, writing two at-the-money calls and buying another higher striking out-of-the-money call. A resulting net debit is taken to enter the trade.

Limited Profit

Maximum profit for the long butterfly spread is attained when the underlying stock price remains unchanged at expiration. At this price, only the lower striking call expires in the money.
The formula for calculating maximum profit is given below:
  • Max Profit = Strike Price of Short Call - Strike Price of Lower Strike Long Call - Net Premium Paid - Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Short Calls
Graph showing the expected profit or loss for the butterfly spread option strategy in relation to the market price of the underlying security on option expiration date.
Butterfly Spread Payoff Diagram

Limited Risk

Maximum loss for the long butterfly spread is limited to the initial debit taken to enter the trade plus commissions.
The formula for calculating maximum loss is given below:
  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying <= Strike Price of Lower Strike Long Call OR Price of Underlying >= Strike Price of Higher Strike Long Call

Breakeven Point(s)

There are 2 break-even points for the butterfly spread position. The breakeven points can be calculated using the following formulae.
  • Upper Breakeven Point = Strike Price of Higher Strike Long Call - Net Premium Paid
  • Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid

Example

Suppose XYZ stock is trading at Rs40 in June. An options trader executes a long call butterfly by purchasing a JUL 30 call for Rs1100, writing two JUL 40 calls for Rs400 each and purchasing another JUL 50 call for Rs100. The net debit taken to enter the position is Rs400, which is also his maximum possible loss.
On expiration in July, XYZ stock is still trading at Rs40. The JUL 40 calls and the JUL 50 call expire worthless while the JUL 30 call still has an intrinsic value of Rs1000. Subtracting the initial debit of Rs400, the resulting profit is Rs600, which is also the maximum profit attainable.

Maximum loss results when the stock is trading below Rs30 or above Rs50. At Rs30, all the options expires worthless. Above Rs50, any "profit" from the two long calls will be neutralised by the "loss" from the two short calls. In both situations, the butterfly trader suffers maximum loss which is the initial debit taken to enter the trade.


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