Butterfly spread

Definition

A butterfly spread is an options trading strategy that involves using multiple options contracts to create a position with limited risk and limited profit potential. This strategy typically consists of buying and selling options at three different strike prices, all with the same expiration date, to profit from low volatility in the underlying asset. The goal is to make a profit when the asset's price remains near the middle strike price at expiration.

5 Must Know Facts For Your Next Test

1. A butterfly spread can be created using either call or put options, depending on the trader's outlook on market volatility.
2. The maximum loss in a butterfly spread occurs if the underlying asset's price is significantly above or below the outer strike prices at expiration.
3. The maximum gain from a butterfly spread happens when the underlying asset's price is exactly at the middle strike price at expiration.
4. Butterfly spreads are ideal for traders who expect low volatility and want to profit from time decay as the options approach expiration.
5. There are variations of butterfly spreads, including long and short butterfly spreads, which differ based on whether the trader expects the underlying asset to stay near the middle strike price or move away from it.

Review Questions

• How does a butterfly spread function as a trading strategy and what are its key components?
  • A butterfly spread functions as a trading strategy by involving three different strike prices for options contracts, which allows traders to capitalize on low volatility in the market. The key components include buying one option at a lower strike price, selling two options at a middle strike price, and buying one option at a higher strike price. This setup creates a defined risk profile where potential profits are maximized if the underlying asset closes at the middle strike price at expiration.
• Discuss the risk-reward profile of a butterfly spread compared to other options strategies.
  • The risk-reward profile of a butterfly spread is unique because it offers limited risk and limited profit potential. Unlike more aggressive strategies like straddles or strangles, which can yield higher profits in volatile markets, the butterfly spread limits losses to the initial premium paid for entering the position. This makes it suitable for traders who expect minimal movement in the underlying asset's price. In comparison, strategies like vertical spreads also have limited risk but generally provide higher potential profits due to wider price movement scenarios.
• Evaluate how changes in market conditions can impact the effectiveness of a butterfly spread strategy.
  • Market conditions significantly impact the effectiveness of a butterfly spread strategy because it relies on low volatility to succeed. If market volatility increases unexpectedly, the underlying asset may move away from the targeted middle strike price, leading to losses instead of profits. Additionally, changes in implied volatility can affect option premiums and overall profitability. Traders must monitor market conditions closely, as an increase in volatility often favors other strategies that benefit from larger price swings, making them more attractive than a butterfly spread during such times.

Related terms

options: Contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a specific date.

vertical spread: An options strategy that involves buying and selling two options of the same class with different strike prices or expiration dates.

iron condor: A complex options strategy that involves holding two vertical spreads with different strike prices, providing a wider range for potential profit compared to a butterfly spread.