What is a Butterfly Spread?

A butterfly spread is an options trading strategy that involves three different strike prices with the same expiration date. It uses either call options or put options, or a combination of both.

Basic Structure

The basic structure of a butterfly spread involves buying and selling options contracts in a specific ratio: 1:2:1. For example, if you’re setting up a long call butterfly spread, you would buy one in-the-money call option, sell two at-the-money call options, and buy one out-of-the-money call option.

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Components of a Butterfly Spread

Long Call Butterfly Spread

• Setup: To set up a long call butterfly spread, you buy one in-the-money call option, sell two at-the-money call options, and buy one out-of-the-money call option.

• Maximum Profit: The maximum profit scenario occurs when the underlying asset expires exactly at the middle strike price. Here, all options expire worthless except for the in-the-money and out-of-the-money calls which are exercised.

• Breakeven Points: The breakeven points are calculated based on the premiums paid and received. For instance, if you buy an in-the-money call for $10, sell two at-the-money calls for $5 each ($10 total), and buy an out-of-the-money call for $5, your breakeven points would be slightly above and below these strike prices after considering premiums.

• Maximum Loss: The maximum loss is capped at the net premium paid for setting up the trade.

Long Put Butterfly Spread

• Setup: A long put butterfly spread involves buying one in-the-money put option, selling two at-the-money put options, and buying one out-of-the-money put option.

• Maximum Profit: Similar to the long call butterfly spread, maximum profit occurs when the underlying asset expires at the middle strike price.

• Breakeven Points & Maximum Loss: The breakeven points and maximum loss calculations are similar to those of the long call butterfly spread but applied to puts.

Short Butterfly Spread

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  Setup: A short butterfly spread involves selling options instead of buying them. For example, you would sell one in-the-money call option, buy two at-the-money call options, and sell one out-of-the-money call option.

• Maximum Profit Scenario: Maximum profit occurs when the underlying asset moves beyond the outer strike prices. Here, all options expire worthless.

Iron Butterfly Spread

• Setup: An iron butterfly spread combines a short call butterfly spread with a short put butterfly spread. This involves selling an in-the-money call and put while buying an at-the-money call and put and selling an out-of-the-money call and put.

• Maximum Profit Scenario: Maximum profit occurs when the underlying asset stays at or very close to the middle strike price at expiration.

Identifying Optimal Strike Prices and Expiration Dates

Selecting the right strike prices is crucial for the success of your butterfly spread. You need to project the price range of the underlying asset based on your market analysis. Here are some tips:

• Choose strike prices that align with your expectations for volatility and price movement.

• Consider using technical analysis tools to identify potential support and resistance levels.

• Ensure that your chosen expiration date gives enough time for your trade to play out but not so much that time decay (theta) erodes your profits significantly.

Risk and Reward Analysis

The risk profile of a butterfly spread is characterized by limited risk but also capped profits.

Calculation of Maximum Profit

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The maximum profit is calculated by subtracting the net premium paid from the difference between strike prices.

Calculation of Maximum Loss

The maximum loss is equal to the net premium paid for setting up the trade.

Breakeven Points

Breakeven points are calculated by adding or subtracting half of the net premium from each strike price.

Managing the Trade

Managing a butterfly spread requires constant monitoring, especially as expiration approaches.

• Keep an eye on volatility changes as they can affect your trade’s profitability.

• Be prepared to close parts or all of your position before expiration if it becomes clear that your initial thesis is incorrect.

• Understand how exercise and assignment work so you can avoid unwanted positions.

Advanced Variations: Modified Butterfly Spread

A modified butterfly spread uses a different ratio than the traditional 1:2:1 setup; it often uses a 1:3:2 ratio.

Increased Risk & Potential Reward

This variation increases both potential reward and risk compared to the standard butterfly spread.

Active Management & Time Decay (Theta)

Active management becomes more critical here due to increased complexity. Time decay (theta) can also play a significant role in managing this trade effectively.

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