Butterflies are as unique in the market as they are in nature. They come in all different shapes, sizes, and colors. You can pick your favorite and follow its movement.
We all know what butterflies are, but what are butterflies in the stock market?
Butterfly spreads are a set of distinguished options strategies, or plays. They come in various forms that have different ways of profiting, so they can be used in different scenarios, and at the same time the cap risk. Sometimes with options you can expose yourself to unlimited risk, but not with butterfly spreads.
To be fair, there is also a cap on the maximum amount of profit, but this is made up for in the nature of the strategies, as they are designed to be balanced, and hedged.
We’re going to give you a complete guide of butterfly spreads, let’s jump in.
What you’ll learn
What Exactly is a Butterfly Spread?
A butterfly spread is an options technique for experienced traders. Options are investment vehicles that are associated with an underlying asset, and allow investors to buy or sell the asset they’re associated with at a set price over a set period of time.
The strategy is built from two less complicated options strategies, namely, a combination of both bear and bull spreads. Essentially, when you first start trading options, it’s common to simply long either a call or a put. The next step would be to use plays such as straddles, strangles, and spreads, which require the investor to simultaneously buy two options.
Butterfly spreads would be the next step, entering the more advanced realm of plays. These types of spreads involve four different options contracts (either four calls, four puts, or two of each).
A butterfly spread can be an attractive strategy for investors to use, because one unique aspect of some forms of butterfly spreads is that you actually want the underlying asset’s price to stay relatively neutral, so you can profit from very little volatility. That’s how you profit with some forms of the strategy. This is not something you see when trading in the normal market, as you can normally only profit from a rise or fall in price depending on if you long or short stock.
Further, while butterfly spreads can capture profit from low volatility, they can also capture profit from high volatility. It all depends on the calls and puts you use, and which ones you buy (long) and with which ones you sell (write, or short).
Understanding How the Butterfly Spread Works
It’s a good idea to first understand the basics of options, and then gradually build off of that knowledge so that more advanced plays are easier to grasp. The reason being, it would kind of be like trying to learn algebra before you learn addition and subtraction. Regardless, we’ll explain in a way that’s relatively easy to digest.
So how exactly do butterfly spreads work? Butterfly spreads are built from a variety of combinations of four calls, four puts or a mixture of both, with three different strike prices. The distance of the higher and lower strike prices need to be the same distance from each other relative to the at-the-money strike price.
For example, say Apple (AAPL) is trading at $135 – to create a long butterfly spread, an investor could buy one APPL call with a strike price of $130, write two at $135, and buy the fourth call at $140. Notice that the difference of both the higher and lower strike price relative to the at-the-money strike is $5.
With the difference in strike prices, you can start to understand why this is a “spread” – as in, the strike prices are quite literally spread out. As far as the expiration dates, with butterfly spreads, all four contracts will have the same date.
Different Types of Butterfly Spreads
In options trading, there are many different types of ‘spreads’, such as the put credit spread (aka a bull put credit spread), or a call debit spread (bull call debit spread). Yet these are not butterfly spreads; instead, they involve either two calls or two puts. One you long and one you short. You’ll notice in the names of the strategies they either say credit or debit. This refers to either having a net credit (money coming into your account in the form of premium), or a net debit (money going out of your account).
So if you sell a contract that has a higher premium than the one you bought, you will receive a net credit, and visa versa. This is similar to how butterfly spreads work, you will either end up with a net credit or net debit depending on the contracts you long and short.
Below are the specifics of the various types of butterfly spreads.
Long Call
The long call butterfly spread is the same as the example above with Apple. It is when an investor longs one in-the-money call (for calls, a strike price below the current underlying price), then shorts (or sells/ writes) two at-the-money calls, and lastly, longs an out-of-the-money call (a strike price above the current underlying). This results in a net debit.
Max profit: The strike price of the written calls, minus the strike price of the in-the-money call, minus the premiums paid for the purchased calls.
Max loss: The premiums paid for the purchased calls.
When to use: During low volatility. A long call butterfly spread is most effectively utilized when an investor thinks the underlying price will remain fairly neutral, as in, staying close to the at-the-money strike prices.
Key points: The max profit for long calls is normally infinite, but because of the short positions the profit is capped. This is a double edged sword though, as loss is capped also.
The max loss for a long call (and long put) butterfly spread is the same as if you were to long just one call or put option. You cannot lose more than the amount you initially spent on the position, this is why butterfly spreads have a risk cap.
A three-part strategy known as a long call butterfly spread is created by purchasing one call at a lower strike price, selling two calls at a higher strike price, and then buying one call at an even higher strike price.
Short Call
A short call butterfly spread is sort of the inverse of a long call butterfly spread. Meaning, to set this play up, the investor needs to sell an in-the-money call, this would be the lower strike price (instead of buying as you would with a long call), buy two at-the-money calls, and lastly, sell an out-of-the-money call, the higher strike price. This results in a net credit.
Max profit: The premiums received from the written calls. Since this play creates a net credit, the name of the game is to keep that credit, or premium.
Max loss: The strike price of the purchased calls, minus the strike price of the in-the-money call, minus premiums paid for the purchased calls.
When to use: High volatility. A short call butterfly spread realizes the most profit when the underlying price is volatile, and moves outside the range of the strike prices.
Key points: The maximum profit of short call (and short put) butterfly spreads works in the same way as writing just a single call or put – your goal is to keep the initial premium received from the written calls, this is why there is a cap on profit.
Regarding max loss, normally with short positions the max loss is theoretically infinite, but the great thing about butterfly spreads is that the max loss is capped.
Selling one call at a lower strike price, purchasing two calls at a higher strike price, and selling one call at an even higher strike price combine to form the short call butterfly spread.
Long Put
A long put works the same way as a long call butterfly spread, the only difference being that it involves four puts and not four calls. So an investor would sell two at-the-money puts, buy one with a strike price higher than the current underlying price (in-the-money), and buy one that has a lower strike price than the underlying (out-of-the-money). The results in a net debit.
Max profit: The strike price of the in-the-money put, minus the strike price of the written puts, minus the premiums paid for the purchased puts.
Max loss: The premiums paid for the purchased puts.
When to use: During low volatility. Similar to the long call, a long put butterfly spread is a good strategy when the underlying price stays as neutral as possible.
Key points: Max profit works almost the same as it would with a regular long put, except with a long put butterfly spread you need to also subtract the strike price of the written puts.
Max loss works the same way as a regular put, the worst that can happen is the option expires worthless and you lose what you initially spent on the contract(s).
If the stock price is equal to the center strike price on the expiration date, the long butterfly spread with puts makes its biggest profit.
Short Put
You’re probably starting to pick up a pattern here – a short put butterfly spread works the same as the short call butterfly spread, just with puts. An investor would buy two puts at-the-money, sell a put with a strike price lower than the at-the-money strike price (out-of-the-money), and sell another with a strike price higher than the at-the-money strike price (in-the-money).
Max profit: The premiums received from the written puts; same as a short call butterfly spread.
Max loss: The strike price of the in-the-money put, minus the strike of the at-the-money put, minus the premiums paid for the purchased puts.
When to use: During high volatility, similar to a short call butterfly spread. This is because the optimal condition for this specific play is to have the underlying price above the higher strike or below the lower strike.
Key points: Maximum profit works in the same way as a short call butterfly spread only with puts – profit is capped at the amount of initial premium received from the written puts.
As we’ve touched on, max loss for butterfly spreads is capped, but normally with a short put your loss is unlimited.
The short put butterfly spread is a trend neutral strategy that is bullish on volatility. It assumes that asset prices will not rise above a certain level.
Iron Butterfly Spread
Now we’re starting to enter new territory. With the previous four plays discussed, they involved four of the same type of contract, just with different combinations of either buying or selling.
Iron butterflies are a little different – the difference being that iron butterfly spreads involve both calls and puts, sort of like a straddle. And while they are a different setup than butterfly spreads, an iron butterfly’s max profit and loss works similarly to short butterfly spreads.
To create an iron butterfly, aka a short iron butterfly, an out-of-the-money put is purchased, then an at-the-money call and an at-the-money put are written, lastly, an out-of-the-money call is purchased. This results in a net credit.
Max profit: As with the short butterfly spreads, your max profit equals the premiums received from the call and put that were written.
Max loss: The strike price of the purchased call, minus the strike price of the written call, minus the premiums received from call and put that were written.
When to use: If low volatility is predicted. This is because the trades result in a net credit, so you want the price to stay as close as possible to the underlying price, or the at-the-money strike price.
The iron butterfly strategy is a credit spread in which four options are combined to limit both risk and possible reward.
Reverse Iron Butterfly Spread
A reverse iron butterfly spread is, you guessed it, the reverse of the iron butterfly. Namely, for every put you write, you buy, and for every put you buy, you write. The max profit and loss works similarly to long butterfly spreads. These are also referred to as long iron butterflies.
So a reverse, or long iron butterfly is set up by writing two out-of-the-money options, one call with a higher strike price, and one put with a lower strike price. Next, two options need to be purchased, one at-the-money call, and one at-the-money put. This results in a net debit.
Max profit: The strike price of the written call, minus the strike price of the purchased call, minus the premiums paid for the purchased call and put.
Max loss: The premiums paid for the purchased call and put.
When to use: The reverse iron butterfly is best used in situations where you predict high volatility because you want the price to go above or below the higher or lower strike prices.
Reverse iron butterflies are essentially long straddles with short options sold out-of-the-money, lowering the cost basis but limiting profit possibilities.
The Shape of the Plays
Many options plays, when graphed, often resemble the name of the strategy, or play itself. In the image above, you can see the two ‘wings’ on either side, divided by a line in the middle. This is what creates the abstract image of a butterfly.
Other plays, like the straddle, also resemble their name but not necessarily visually, they’re more like the definition of the word itself. For example, to straddle means “to sit or stand with one leg on either side of”. When you think of a straddle, you have a call and a put, two investments that offset, or mirror each other, as if you have one foot on either side.
Spreads are created when you have two options, but the strike prices, expirations dates, or both, they are literally spread out.
Iron condors are similar to iron butterflies, except the actual animal, the condor (a large bird), is a lot wider than a butterfly, you can see the difference when you graph the profit/ loss of an iron condor. Notice the wide, horizontal line in the middle, symbolizing the body of a condor.
An iron condor is a delta-neutral options strategy that makes the maximum profit when the underlying asset does not move much, while the strategy can be tweaked to include a bullish or bearish bias.
Straddle vs. Butterfly
With a basic understanding of straddles and butterfly spreads, you can start to see how the two plays may be similar. Firstly, iron butterflies are more similar to straddles than butterfly spreads, as iron butterflies contain both calls and puts, versus butterfly spreads which only involve either calls or puts, not both.
Straddles are best utilized when there is high volatility in the underlying price, so they can be used in the same market conditions as short butterfly spreads and iron butterflies.
When contrasting the plays, the first thing to note is that butterflies are more advanced than straddles because they are a little more involved. To be more specific, straddles include two contracts (a call and a put) with the same strike price and expiration date, while butterflies involve four contracts (either four calls or four puts or a combination of both) with three different strike prices.
Lastly, while both plays have a limit to the risk you take on, butterflies have a limited reward, and straddles, theoretically, have unlimited reward potential.
The strategy an investor chooses to employ is almost entirely circumstantial. Both have their costs and benefits, and those need to be weighed before any decision is made. Sometimes it may be more conducive to use a butterfly if there is a prediction of low volatility, where a straddle would be better to use if you want to use less advanced play, and you predict high volatility.
Pros and Cons
Invariably, investors should weigh the pros and cons of any position they decide to open. And while there are many benefits to butterfly spreads, there are also costs, figuratively speaking. One huge benefit to butterfly spreads is their flexibility. They can be used in a variety of market situations, while at the same time capping risk.
One downside to butterfly spreads, if you’ve never learned about or used them, is the steep learning curve that comes with using them effectively. And, even if you know them well enough to be able to explain them to somebody, it is a completely different ball game when they’re actually put into practice. So just remember to be patient if you’re just getting started. Give yourself some time for your strategy to become profitable.
When is the Right Time to Use Butterfly Spread?
One thing that separates butterfly spreads from many other plays is how diverse they are. Depending on varying combinations of calls and puts, butterfly spreads can be used in maybe different market scenarios.
If you are predicting low volatility, or small bullish growth, short butterfly spreads and iron butterflies are your friend. If you think that there is going to be higher volatility, you can set up a long butterfly spread or a reverse iron butterfly.
If you choose the latter, make sure the range of your strike prices is reasonable. A good tip is to look at a stock’s beta, or its measure of its volatility compared to the overall market. If the stock has a high beta (below 1.00, meaning it’s less volatile than the market), and you don’t predict too much volatility, it’s probably not a good idea to use a long butterfly spread or a reverse iron butterfly, and instead use a short butterfly spread or iron butterfly.
Conclusion
Butterfly spreads are an advanced, exotic options strategy, or play, used by investors to capture profit in different ways using various combinations of calls and/ or puts. If you understand the basics of calls, puts, and spreads, you have a strong foundation to build your understanding of butterfly spreads.
The information may seem confusing at first – the best way to help the concepts stick is to employ the strategies yourself so you have the experience. If you are reluctant to throw your money at a play, you can always receive options signals from a team of experienced traders or use an options trading simulator to get your feet wet before you try the plays on the open market.
Butterfly Spreads: FAQs
What is a Butterfly Call Spread?
A butterfly call spread is an advanced options strategy used to capture profit that involves four calls and three different strike prices. With a long call butterfly spread, the investor using the strategy will write two calls that are at the money, and buy two more calls that are above and below the current underlying price (at the money), and these two strike prices are equidistant from the at-the-money calls.
Is a Butterfly Spread Bullish?
A butterfly call spread is not necessarily considered bullish, but instead, typically, it is considered a neutral, to moderately bullish.
When Should I Buy Butterfly Spread?
You can use a butterfly spread in a variety of different situations. It depends on if you think there is going to be low or high volatility, as different butterfly spreads can be used for both.
Do You Have to Close a Butterfly Spread?
No, you are not obligated to close a butterfly spread. However, if you do not close it, and you use a spread that results in a net debit, you risk having the options expire worthless, and you would lose the initial premium you paid for the long positions. It’s almost always a good idea to close your long options positions before they expire.
Are Butterfly Spreads Risky?
No, butterfly spreads are not inherently risky. The great thing about the play is that it has a cap on risk.
How Do You Hedge Butterfly Spread?
Butterfly spreads are inherently hedged, meaning, they are designed to hedge themselves because of the balance between both long and short positions. Additionally, there is a risk cap, so there is a limit to maximum loss.
