1. Getting Started
These are the top 5 butterfly spread option strategy, always chosen by the professionals for maximizing their profits in a neutral market. Unlike trading equity in more traditional financial markets, options trading utilizes a form of derivative contracts that grants both buyer and seller new approaches to making profits. However, trading with this kind of financial instrument is not something that is too common and intuitive for any trader to understand.
2. Butterfly Spread Definition
What is a Spread?
Generally speaking, a spread refers to the difference between two specific financial values. They can either be two prices, rates, yields, and so on. The bid-ask spread is one of the most common types of spreads, referring to the distance between the bid and the ask prices of a certain financial instrument.
What is a Butterfly Spread?
In finance, a Butterfly Spread options strategy is a non-directional strategy that is designed to benefit from little movements of the market and utilized to significantly increase the probability of winning trades while limiting all the lurking risks. During such a strategy, users usually expect the future volatility of the underlying assets to be either lower (when long) or greater (when short) than the current state of the implied volatility.
A butterfly spread option strategy can be regarded as the combination of both a bear spread and a bull spread and applied in a neutral market expected with little movement. A basic butterfly spread usually contains four options contracts with the same expiration date and three different strike prices – a high one, an at-the-money one, and a lower one.
Combining the basic butterfly spread with puts and calls will create more varieties of butter spreads and new approaches to benefit yourself from trading options contracts while being adaptable to any extent of volatility.
3. Type of Butterfly Spread Option Strategy
Long Butterfly Spread With Puts
The long butterfly spread with puts setup:
- Sell two at-the-money put options (strike price B)
- Buy an in-the-money put option with a lower value (strike price A)
- Buy an out-of-the-money put option with a higher value (strike price C)
- All contracts have the same expiration date
As the strategy benefits from the stability of the market movements, the long butterfly spread with puts reaches its potential when the stock price is at the same value as that of written puts at the expiration date. The option buyer will then have a chance to receive a maximum profit that is equal to the strike price C minus strike price B and any premium or commission paid.
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| Long Butterfly Spread With Puts |
Long Butterfly Spread With Calls
The long butterfly spread with calls setup:
- Sell two at-the-money call options (strike price B)
- Buy an in-the-money call option with a lower value (strike price A)
- Buy an out-of-the-money call option with a higher value (strike price C)
- All contracts have the same expiration date
Just like the long butterfly spread with puts, this strategy is expected to reach the highest profitability as long as the stock price stays close to the strike price B. In short, the closer they are, the lower volatility should be, and vice versa.
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| Long Butterfly Spread With Calls |
Short Butterfly Spread With Puts
Short butterfly spread with puts setup:
- Buy two at-the-money put options (strike price B)
- Sell an in-the-money put option with a lower value (strike price A)
- Sell an out-of-the-money put option with a higher value (strike price C)
- All contracts have the same expiration date
This kind of butterfly spread is obviously the reverse version of the two aforementioned strategies. To realize the maximum profit with this approach, you – the option writers – will want the price of the underlying asset to stay outside the two outer strike prices (A and C). The gains are the premiums paid by the option buyers. The loss is only limited to the amount calculated by having strike price C minus strike price B as well as the premiums received.
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| Short Butterfly Spread With Puts |
Short Butterfly Spread With Calls
Short butterfly spread with calls setup:
- Buy two at-the-money call options (strike price B)
- Sell an in-the-money call option with a lower value (strike price A)
- Sell an out-of-the-money call option with a higher value (strike price C)
- All contracts have the same expiration date
In this version of the short butterfly spread, we utilize calls instead of puts to be more adaptable to the movements of the market. A net credit is usually created as the trader initiates the contract. Just like its counterpart of short butterfly spreads, this strategy achieves its full profitability if the stock price manages to go anywhere else except for the gap between strike price A and strike price C.
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| Short Butterfly Spread With Calls |
Iron Butterfly Spread
Iron butterfly spread setup:
- Sell an at-the-money put option (strike price B)
- Sell an at-the-money call option (strike price B)
- Buy an out-of-the-money put option with a lower value (strike price A)
- Buy an out-of-the-money call option with a higher value (strike price C)
- All contracts have the same expiration date
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| You want all four option contracts to expire worthless for maximizing your profit thanks to the premiums paid by the buyers. |
The iron butterfly utilizes both calls and puts to create one more version of butterfly spreads for traders to consider in their trading system. This strategy is best suited for a neutral market with an insignificant state of volatility. If the price of the underlying manages to stay as close to the strike price B as possible, the trader who initiated this strategy will receive premiums as his gains.
4. In conclusion
At first glance, the butterfly spread option strategy share significant similarities that can easily get newcomers greatly confused. But if you actually take your time to digest the information, you will soon come to find out that each strategy is tailored to making the most out of certain situations. What is left for you to do is identify those opportunities and make your decisions to seize your deserved earnings.
Article Source: https://libraryoftrader.net/butterfly-spread-option-strategy