Mechanics of a Butterfly Spread

Mechanics of a Butterfly Spread

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Traders, as well as long-term investors, know how to make money in uptrends either by purchasing stock or utilizing call options for leverage. Most active traders are also aware that they can profit in downtrends by short-selling or by purchasing put options. Making money while the market drifts sideways can be frustrating for both bulls and bears. Butterfly spreads are one method of generating profit during periods of range-bound, sideways price movement. The long butterfly spread is a three-leg strategy that is appropriate for a neutral forecast – when you expect the underlying stock price (or index level) to change very little over the life of the options.

A butterfly spread is constructed by selling two options at the middle strike and buying one option at the higher and lower strikes. The options, which must be all calls or all puts, must also have the same expiration and underlying. While the short options can be sold at any strike, selling options at or near the current price of the underlying works well because at-the-money options have the most time-value and take advantage of the time decay in those options.

Here is the profit and loss graph for a butterfly spread at expiration:

Maximum profit for the long butterfly spread is attained when the underlying stock price remains unchanged at expiration. At this price, only the lower striking call expires in the money.

Calculating maximum profit:

  • Max Profit = Strike Price of Short Options- Strike Price of Lower Strike Long Option – Net Premium Paid – Commissions
  • Max profit occurs when the price of the underlying = the strike price of the short options

Maximum loss for the long butterfly spread is limited to the initial debit paid to enter the trade plus commissions.

Calculating maximum loss:

  • Max Loss = Net Debit Paid + Commissions
  • Max loss occurs when the price of the underlying <= the strike price of lower strike long option OR the price of the underlying >= the strike price of the higher strike option

As the profit and loss graph makes evident, there are 2 break-even points for a butterfly spread position.

Calculating the breakeven points:

  • Upper Breakeven Point = Strike Price of Higher Strike Long Option – Net Debit Paid
  • Lower Breakeven Point = Strike Price of Lower Strike Long Option + Net Debit Paid

 

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