Option Butterfly Strategy – What is a Butterfly Spread

Butterflies are neutral, cheap, low probability option strategies with relatively high potential payouts if used correctly. They have similar payoffs as calendar spreads but work quite differently. There are different ways to set up butterfly spreads. I will cover the most common ones here.

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Video Breakdown:

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Long Butterfly Option Strategy

Market Assumption:

When trading long butterfly spreads you should definitely have a neutral/range bound market outlook. You should expect that the price of the underlying asset only will move little. But different from Iron Condors, Strangles and Straddles butterfly spreads are much tighter and don’t allow the price to move that much. Therefore, long butterfly spreads are not suited for high probability trading. You can either set up a butterfly spread with calls or puts:

Setup:

• Buy 1 ITM Call
• Buy 1 OTM Call
• Sell 2 ATM Calls

or

• Buy 1 OTM Put
• Buy 1 ITM Put
• Sell 2 ATM Puts

This should result in a debit (Pay to open)

Profit and Loss:

As you can see on the payoff diagram a long butterfly spread is both a limited risk and limited profit strategy. The maximum profit is reached rather rarely because to achieve it the price of the underlying has to be exactly at the strike of the two short positions. This is also the reason why butterfly spreads are not very high probability strategies. Maximum drawdown, on the other hand, occurs when the price of the underlying asset is somewhere outside of the two long positions. The strikes of the two long positions are the break-even points (- commissions).

Maximum Profit: Strike of Short Option – Strike of Long Option (Width of Strikes) (*100) – Total Premium Paid – Commissions

Ex. 53 – 50 = 3 (3$ width of strikes) => 3$ *100 – 50$ (Total Premium Paid) – 5$ (Commission) = 245$ (max profit)

(a normal option contract controls 100 shares, therefore *100)

Maximum Loss: Total Premium Paid + Commissions

Ex. 50$ (Premium Paid) + 5$ (Commission) = 55$ (max loss)

Implied Volatility and Time Decay:

Time decay or the option Greek Theta works in favor of long butterfly spreads. Even though you have two long positions, the two short options still profit more from the time decay than the long positions lose from it. Time decay is highest in the last weeks before expiration.

Normally butterfly spreads profit from a drop in implied volatility (IV). This means that it is best to enter a butterfly spread in a high IV environment (IV rank over 50). But if the price moves a certain way after entry a butterfly spread can actually also profit from a rise in IV. So it depends on where the underlying price is. But I would always recommend that you enter this spread in times of high IV. But in general, IV won’t have a too large impact on butterfly spreads.

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Short Butterfly Option Strategy

Next up, let’s take a look at the short butterfly options trading strategy.

Market Assumption:

If you choose to trade a short butterfly spread, you should expect a big move in the near future. The price won’t have to move as far as it would have to in some straddle strategies, but it still has to move a little. Such a small move isn’t unlikely and therefore short butterfly spreads can be used for high probability option strategies. If the underlying asset makes an even bigger move than you expect, you won’t make any more money, because of the limited profit potential of this strategy.

Setup:

• Sell 1 ITM Call
• Sell 1 OTM Call
• Buy 2 ATM Calls

or

• Sell 1 OTM Put
• Sell 1 ITM Put
• Buy 2 ATM Puts

This should result in a credit (You get paid to open)

Profit and Loss:

A short butterfly spread is a defined risk and defined profit strategy, just like you can see on the payoff diagram. The maximum profit is reached as soon as the price of the underlying asset moves a little further than one of the strikes of the short options. The maximum loss occurs when the price of the underlying is exactly at the strike of the two long positions. Max loss won’t occur too often because it only occurs on this very small spot.

Maximum Profit:  Total Premium received – Commissions

Ex. 20$ Premium – 3$ = 17$ (max profit)

Maximum Loss: Strike of Short Option – Strike of Long Option (Width of Strikes) (*100) – Total Premium received + Commissions

Ex. (Strike 50 and 52) => 2$ Width * 100 – 20$ Premium + 3$ Commissions =  183$ (max loss)

(a normal option contract controls 100 shares, therefore *100)

Implied Volatility and Time Decay:

Time decay does not work in favor of a short butterfly spread. This is because it has a negative impact on the long options, which are the most valuable in this strategy. Time decay or the option Greek Theta will increase the closer you get to expiration.

A short butterfly spread usually profits from a rise in implied volatility (IV). Therefore, this strategy is best used in times of low IV (IV rank under 50). But just as said before, IV won’t have a too large impact on butterfly spreads.

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Other Variations

There are a few other butterfly spread variations, like the iron butterfly option strategy. An iron butterfly is very similar compared to a normal butterfly spread. The payoff is exactly the same, but the setup is a little different. The setup reminds of a very narrow iron condor:

Setup

Long Iron Butterfly:

• Sell 1 OTM Call
• Buy 1 ATM Call
• Buy 1 ATM Put
• Sell 1 OTM Put

This should result in a debit (Pay to open)

Short Iron Butterfly:

• Buy 1 OTM Call
• Sell 1 ATM Call
• Sell 1 ATM Put
• Buy 1 OTM Put

This should result in a credit (You get paid to open)

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Trader’s Note:

Iron butterflies work almost the same way as normal butterfly spreads. But a few aspects are a little different. For example, the max profit and max loss are calculated a little differently. Leave a comment if you want me to go more in-depth on iron butterflies.

Otherwise, there are even more variations of butterfly spreads, like the broken wing butterfly. Broken wing butterfly spreads work rather different than normal butterflies do and that’s why I covered them in THIS ARTICLE.