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Butterfly Spreads in Stock Options Strategy
The "butterfly options strategy", also called "butterfly spreads" contain both bullish and bearish options. The trader in butterfly spreads has four options having the same expiry dates but three different strike prices. The trader buys two options contracts that have a higher and lower price, and two contracts with a price in between. The difference between high and low strike price is equal to the strike price in between.
A butterfly strategy contains the following −
- Buying or selling of Call/Put options
- Combining four option contracts
- Same underlying asset
- Same expiry date
- Different strike prices, with two contracts at same strike price
Explanation
Butterfly spreads work the best in a non-volatile and comparatively stable market where a trader can earn some profit without having to take too much of risk. The best result of the butterfly strategy is seen when the options are near the end and at-the-money (ATM) or, in other words, when the price of the underlying assets is equal or near the middle strike price.
In this strategy, the trader can deal in calls and puts or a mix of both. Similarly, one can go for a long or short options depending on what they foresee and what the payoff of the options will be.
Long Call/Put Butterfly
This strategy involves buying one options with a higher strike price and one at a lower strike price and selling two options simultaneously at a strike price near to cash price of same expiry and underlying assets.
The strategy has limited risk and the maximum a trader can lose is equal to the cost of the Call and Put options which will occur when the cash price goes beyond the upper strike price or below the lower strike price.
Upper Breakeven Point in Butterfly spread = Higher strike price long Call/Put option (Strike Price − Premium paid (Value of option)
Lower Breakeven Point in Butterfly spread = Lower strike price long Call/Put option (Strike Price + Premium paid (Value of option)
Short Call/Put Butterfly Option
In this strategy, one call/put option is sold at a higher price and another at a lower price while two options are bought simultaneously at a strike price near the cash price of the same underlying assets and of same expiry.
The price of long call/put options is the maximum loss a trader can suffer from in this strategy and it occurs when the cash price is at the same level with the middle strike price. When the cash prices are beyond the upper and lower strike prices, the maximum profit is obtained.
Upper Breakeven Point in short Butterfly = Higher strike price long Call/Put option (Strike Price − Premium paid (Value of option)
Lower Breakeven Point in short Butterfly= Lower strike price long Call/Put option (Strike Price + Premium paid (Value of option)
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