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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
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. 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
Short Butterflies
Overview: Nondirectional. Expect the stock to make a large move higher or lower but not sure of direction.
Established using all calls or puts and is done for a net credit. For example, a short call butter?y is created by selling a call, purchasing two calls at a higher strike price, and selling another call at even higher strike, with the strike prices evenly apart. The number of long options equals the number of short options. The maximum reward occurs when the stock moves beyond the breakeven points
Position: Short $45 Call/Put long two $50 Calls/Puts
short $55 Call/Put.
Maximum risk: Difference between long and short strikes credit
received.
Maximum reward: Limited to credit received.
Breakeven points: (a) Lowest strike credit received.
(b) Highest strike credit received.
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