Understanding
Stock Options Trading
and Technical Analysis Basics

Butterfly Spread Options

Butterfly spread options are composed of 2 vertical spreads that have a common strike price. In other words, butterfly options involve an opening position where options (either calls or puts) are bought (or sold) at 3 different strike prices. The way in which these options are created makes the butterfly a position that has both limited losses and limited profits.

The Long Butterfly spread option can be created using either all call options or all put options. Due to put-call parity, a Long Butterfly created using call options will behave like one created using put options. In other words, it doesn't really matter whether you use calls or puts to create your Long Butterfly. Our example here will focus on the version using call options.

The Long Butterfly can be created by buying an In-the-Money (ITM) call option, selling 2 At-the-Money (ATM) call options and buying another Out-of-the-Money (OTM) call option. This is actually a combination of 2 opposing vertical spread options, hence why the butterfly is also known as the Butterfly Spread.

Long Butterfly - Buy 1 ITM Call, Sell 2 ATM Calls, Buy 1 OTM Call
Long Butterfly - Buy 1 ITM Call, Sell 2 ATM Calls, Buy 1 OTM Call

Combining the profit profile of these 4 call options, you will find that if the stock price falls, you will face limited losses (which is the initial premium you paid for the entire butterfly trade). Similarly, if the stock price climbs too high, you will also face limited losses. However, if the stock price stays around the vicinity of the ATM option strike price, you will receive limited profit.

This makes the Long Butterfly a good neutral option strategy for low volatility, since you are betting on the stock price not moving much in order to collect maximum profits. It is also a low-risk strategy, since your losses are limited if the stock crashes or climbs unexpectedly. Unfortunately, this is accompanied by limited profits as well. As has been mentioned above, the Long Butterfly can also be created using all put options instead of all call options.

Summary:

The Long Butterfly option spread involves buying an ITM call, selling 2 ATM calls and buying an OTM call. It is a neutral low-risk strategy for low volatility stocks. You reach maximum limited profits if the stock doesn't move much. You will incur maximum limited losses if the stock climbs too high or falls too low.

The Short Butterfly strategy is the opposite of the Long Butterfly. The spreads are reversed, and the strategy is used for volatile stocks.

One warning about both Long and Short Butterfly spreads: these positions involve buying and selling options at 3 strike prices. For most option brokers, this means you will be paying 3 commissions to open the position, and another 3 commissions to close it. You will need to consider these extra commissions (which differ from broker to broker) when trying to determine if the Butterfly will be profitable for your circumstances.