A butterfly spread is a well-known options trading strategy that is designed for situations where an investor expects an underlying asset's price to remain stable. This strategy derives its name from the distinctive shape of its profit and loss diagram, which, when plotted, resembles a butterfly with outstretched wings.
The core concept behind a butterfly spread is to use a combination of call or put options at three different strike prices to create a structured position that balances potential profit and risk. It is considered a neutral strategy because it is not based on the assumption that the underlying asset will significantly rise or fall in price. Instead, it thrives in scenarios where the asset's price remains relatively unchanged or within a narrow range.
Option strategy - Constructing a butterfly spread
A butterfly spread is constructed with a specific combination of options that allows traders to benefit from stability in the underlying asset's price. To set up a butterfly spread, you will need to follow a well-defined process:
- Select an underlying asset: First, identify the underlying asset you want to work with, such as a stock, commodity, or currency.
- Determine the strike prices: The key to constructing a butterfly spread is to choose three strike prices. These should be in a specific sequence: a lower strike price (below the current market price), a middle strike price (often set near the current market price), and a higher strike price (above the current market price).
- Choose option types: Decide whether you want to use call options or put options. A butterfly spread can be constructed using either call options or put options.
- Execute the trades: Once you have determined the three strike prices and selected your option types, you will execute four separate options trades. These trades consist of buying one option at the lower strike price, selling two options at the middle strike price, and buying one option at the higher strike price.
- Options expiration: Ensure that all the options used in the strategy have the same expiration date. This is crucial to the effectiveness of the butterfly spread.
The middle strike price serves as the pivot point of the strategy and is often set near the current market price of the underlying asset. It is the area where the maximum profit potential is achieved if the asset's price remains stable.
Types of butterfly spread
1.Long call butterfly spread:
The long call butterfly spread is a neutral options strategy employed when an investor expects minimal price movement in an underlying asset. It is constructed using call options and consists of three strike prices.
How it works:
- Buy one lower strike call option.
- Sell two middle strike call options.
- Buy one higher strike call option.
The key characteristic of the long call butterfly spread is its symmetrical structure. The middle strike price, where two call options are sold, is usually set at or close to the current market price of the underlying asset. This creates a balanced position. If the market price remains near the middle strike price at expiration, the strategy maximises its profit.
Example: Long call butterfly spread
Suppose an investor believes that the stock of XYZ company, currently trading at Rs. 55, will remain relatively stable over the next month. To profit from this expectation, they can employ a call butterfly spread as follows:
- Buy one call option with a strike price of Rs. 50.
- Sell two call options with a strike price of Rs. 55.
- Buy one call option with a strike price of Rs. 60.
If, at the time of expiration, the stock price of XYZ company remains between Rs. 55 and Rs. 60, the investor will realise a profit from this call butterfly spread.
Profit and loss:
- Maximum profit is achieved when the underlying asset's price equals the middle strike price.
- Maximum loss is limited to the initial cost of setting up the spread.
2.Short call butterfly spread:
In contrast to the long call butterfly spread, the short call butterfly spread is a strategy used when an investor anticipates significant price movement in the underlying asset but is unsure of the direction. It is also constructed using call options and involves three strike prices.
How it works:
- Sell one lower strike call option.
- Buy two middle strike call options.
- Sell one higher strike call option.
The short call butterfly spread is structured to benefit from the volatility of the underlying asset. Profits are realised if the market price deviates substantially from the middle strike price in either direction.
Example: Short call butterfly spread
Suppose you are an options trader interested in a stock, let us call it "ABC Ltd." Currently, ABC Ltd. is trading at Rs. 60 per share, and you anticipate that there will be substantial price movement in the coming months due to upcoming earnings announcements and other market factors. However, you are uncertain about whether the stock will move significantly higher or lower.
To implement a short call butterfly spread, you will use call options at three different strike prices, as follows:
- Sell one call option with a strike price of Rs. 55.
- Buy two call options with a strike price of Rs. 60.
- Sell one call option with a strike price of Rs. 65.
Your initial cost, or the maximum loss, is Rs. 2. In essence, the short call butterfly spread provides options traders with a structured approach to benefit from volatility in the underlying asset while capping potential losses. It is a strategy well suited for situations where significant price movement is expected, but the direction of that movement remains uncertain.
3.Long put butterfly spread:
The long put butterfly spread is a bearish strategy used when an investor expects a significant downward movement in the underlying asset's price. This strategy employs put options and comprises three strike prices.
How it works:
- Buy one higher strike put option.
- Sell two middle strike put options.
- Buy one lower strike put option.
The long put butterfly spread aims to profit from the expected decline in the underlying asset's price. Similar to the long call butterfly spread, it is symmetrical, with the middle strike price often set near the current market price.
Profit and loss:
- Maximum profit occurs if the market price equals the middle strike price.
- Maximum loss is limited to the initial cost of setting up the spread.
Example: Long put butterfly spread
Imagine another scenario where an investor anticipates that the stock of ABC company, currently trading at Rs. 45, will stay within a relatively stable range over the next month. They can employ a put butterfly spread for this purpose:
- Buy one put option with a strike price of Rs. 50.
- Sell two put options with a strike price of Rs. 45.
- Buy one put option with a strike price of Rs. 40.
If, at the time of expiration, the stock price of ABC company remains between Rs. 45 and Rs. 40, the investor will profit from this put butterfly spread.
These examples demonstrate how a butterfly spread allows traders to benefit from price stability by balancing their positions at different strike prices.
Advantages
- Limited risk: Butterfly spreads have a well-defined risk profile. The maximum loss is limited to the initial cost of setting up the spread.
- 56 Versatility: Butterfly spreads can be applied to both call and put options, offering flexibility in trading in various market conditions.
Disadvantages
- Limited profit potential: While this is an advantage in some cases, it can also be a disadvantage when significant price movements are expected.
- Complexity: Constructing a butterfly spread involves multiple options trades, which can be complex and may require a good understanding of options.
- Commissions and costs: The execution of multiple options trades may result in higher trading costs due to commissions.
Conclusion
In summary, a butterfly spread is a valuable tool in options trading, especially when an investor expects the price of an underlying asset to remain stable. This strategy provides a structured approach to balance potential profit and risk, with limited loss exposure. By understanding how to construct a butterfly spread and using it effectively, traders can optimise their positions and capitalise on market stability, making it a key strategy in the options trader's toolkit.
