Long Butterfly Spread (2024)

FAQs

What is a long butterfly put spread? ›

Explanation. A long butterfly spread with puts is a three-part strategy that is created by buying one put at a higher strike price, selling two puts with a lower strike price and buying one put with an even lower strike price. All puts have the same expiration date, and the strike prices are equidistant.

The long call butterfly spread is created by buying a one in-the-money call option with a low strike price, writing (selling) two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. Net debt is created when you enter the trade.

To close a long call butterfly spread before expiration, you simply execute the reverse transactions you executed to open the spread. Remember, a long call butterfly spread involves buying one lower strike call, selling two middle strike calls, and buying one higher strike call.

Also, risk is capped if the market moves sharply in either direction. The primary disadvantage of the butterfly spread is the possibility that the market could move sharply in either direction to incur a loss on the position, and the potential trading costs versus the limited profit potential (see sidebar).

Description: The Butterfly Spread Option strategy works best in a non-directional market or when a trader doesn't expect the security prices to be very volatile in future. That allows the trader to earn a certain amount of profit with limited risk.

The major difference is that Long Call/Put Butterfly strategies are net debit strategies, while Short Iron Butterfly is a net credit strategy.

The basic butterfly can be entered using calls or puts in a ratio of 1 by 2 by 1. This means that if a trader is using calls, they will buy one call at a particular strike price, sell two calls with a higher strike price and buy one more call with an even higher strike price.

Since the volatility in option prices typically rises as an earnings announcement date approaches and then falls immediately after the announcement, some traders will sell a butterfly spread seven to ten days before an earnings report and then close the position on the day before the report.

The Iron Condor has a wider spread and thus a wider profitable zone, which increases the likelihood of making a profit. However, the profit is not so large. The Iron Butterfly has a narrower spread due to the similar strike prices of the two ATM options.

Potential position created at expiration

The position at expiration of a long butterfly spread with calls depends on the relationship of the stock price to the strike prices of the spread. If the stock price is below the lowest strike price, then all calls expire worthless, and no position is created.

Is butterfly spread a vertical spread? ›

A vertical spread involves two options contracts of the same type (either two calls or two puts). Both these contracts should have the same expiration date but different strike prices. An iron butterfly, meanwhile, involves four options contracts (two calls and two puts).

The payoff diagram of a long call butterfly defines the maximum risk and reward. The maximum loss on the trade is defined at entry by the combined cost of the four call options and is realized if the underlying stock price closes above or below the long options at expiration.

The butterfly spread options strategy is a combination of a bull spread and a bear spread, using three strike prices. It involves buying one call option at the lowest strike price, selling two call options at a higher strike price, and buying another call option at an even higher strike price.

A negative butterfly occurs when short-term interest rates and long-term interest rates decrease by a greater degree than intermediate-term interest rates, accentuating the hump in the curve.

What is the risk of the iron butterfly spread? The risk of the iron butterfly spread is the potential maximum loss you can incur if the stock price moves significantly either above or below your established range by the expiration date.

Understanding Butterfly Spread

This arrangement creates a unique payoff structure resembling a butterfly's wings, where the maximum profit is attained if the underlying asset settles at the middle strike price at expiration.

The 1-3-2 ratio is the most common configuration for butterfly spreads. So when we talk about a “short put butterfly” or a “put butterfly spread,” it refers to a 1-3-2 configuration of buying puts at the wings (lower and higher strikes) and selling puts at the body (middle strike).

A short butterfly spread with calls is a three-part strategy that is created by selling one call at a lower strike price, buying two calls with a higher strike price and selling one call with an even higher strike price. All calls have the same expiration date, and the strike prices are equidistant.

Butterfly spreads use four option contracts with the same expiration but three different strike prices spread evenly apart using a 1:2:1 ratio. Butterfly spreads have caps on both potential profits and losses, and are generally low-risk strategies.