Butterfly Spread

| March 26, 2012 | 0 Comments

long butterfly spreadThe butterfly spread is a neutral options strategy, also called the long butterfly spread.  A trader profits from a butterfly spread when the underlying stock is stagnant or trades in a tight price range over the life of the spread.

A butterfly spread is made up of three options trades at once.  It can be done with either all calls or all puts, but for our purposes, we’ll only talk about call butterflies.  If executed properly, a butterfly spread has a higher potential gain than potential loss, and both gains and losses are capped.

Because you’re selling options as part of the spread (you receive money for doing it), the entire strategy is cheaper than many other options strategies.  Basically, selling options as part of the spread helps offset cost of the options you buy.

Let’s take a closer look at the options in a butterfly spread…

As mentioned earlier, the butterfly spread is made up of three option trades.  For one butterfly spread, you buy one out-of-the-money (OTM) call and 1 in-the-money (ITM) call, and sell two at-the-money (ATM) calls.

The choice on which OTM and ITM calls you buy depend on what range you expect the underlying stock to trade in.  However, the OTM and ITM strikes will each be the same distance from the ATM strike.

Let’s look at an example…

Stock XYZ is trading at $50 per share.  Let’s say it’s November and you think XYZ is going to trade in a range between $48 and $52 for the next couple of months.  To put on one January 48-50-52 long call butterfly spread, here’s what you’d do…

  • Buy one Jan 48 Call
  • Sell two of the Jan 50 Calls
  • Buy one Jan 52 Call

Now, let’s add theoretical prices to these options so we can calculate profit/loss potential.

  • Buy one Jan 48 Call for $3.75
  • Sell two of the Jan 50 Calls for $2.00
  • Buy one Jan 52 Call for $1.00

The total cost to you is $0.75 per spread ($3.75 + $1.00 – ($2.00 x 2)).

Remember, you expect XYZ to trade in the $48-$52 range, so your maximum profit will be right in the middle at $50 upon expiration in January.  So, if XYZ closes at $50 in January, your max profit would be $1.25 per spread.  That’s the distance between the OTM or ITM options and the ATM options ($2.00) minus the cost of the spread ($0.75).

Your breakeven for the trade is if XYZ closes between the OTM and ITM strikes on January expiration, after taking into account the cost of the spread.  In this case, your lower breakeven is $48.75 (the 48 strike plus $0.75 spread cost).  The upper breakeven is $51.25 (the 52 strike minus $0.75 spread cost).

You lose money on this trade if XYZ closes out the range of the OTM or ITM strikes plus/minus the cost of the spread (under $48.75 or above $51.25) on January expiration.  Keep in mind, your maximum loss is the cost of the spread.  So you can’t lose more than $0.75 per spread.

Remember, this a good strategy if you expect XYZ to trade in a narrow range through January and close at or near $50.

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Category: Options Trading Strategies

About the Author ()

A former banking executive, Corey Williams is the Chief Options Strategist and co-editor of our well-known daily newsletter, Options Trading Research. Corey’s extensive experience with options goes all the way back to his days in corporate finance. It was this decade in banking where Corey discovered the most important skill an options trader can have– the ability to analyze a company or sector to determine its likely future direction. And now he’s brought this background, experience and love of options to Options Trading Research, the unique daily e-letter devoted exclusively to helping individual investors profit from the very lucrative options market.