Butterfly Spread Strategy | Butterfly Spread Option Strategy | Short, Long Butterfly Spread in Options | Open Free Account Online and Start Trading Today !
Explore the butterfly spread option strategy - a low-risk and predetermined profit method in options trading. Learn how to implement the long butterfly spread strategy, and short butterfly spread strategy, and understand more accurately with examples. Also, explore the merits and demerits of the butterfly spread in options trading.
Butterfly Spread Option Strategy : The Unique Way to Trade Options
Traders use the butterfly spread strategy when there is a limited price movement of the underlying asset. It is a low-risk strategy that allows them to profit from no or minimal price movement along with limiting their potential loss. Butterfly spread in options is most suited in range-bound markets when the traders are aware that the asset will expire at a specific- level. This butterfly spread option strategy offers a mix of risk and rewards to the option traders.
The long and short butterfly spread strategy is made using the three different strike prices of the asset and involves the combination of buying and selling option contracts. It is created in such a way that traders get a profit from the center zone in the stable market scenario. It is generally implemented when the volatility is low and also traders are looking for minimum risk exposure on their position.
What is the Butterfly Spread Option Strategy ?
The butterfly spread strategy is one of the advanced option trading strategies in which long and short positions are created to create a symmetrical payoff structure. It uses the three strike prices having equal distance and equal number of contracts being bought and sold.
This butterfly spread option strategy can be executed with either call option contracts or put option contracts. It generates profits when the contracts expire near the middle strike price. When traders expect low volatility and still want to have a defined risk-to-reward ratio, they use this strategy.
Types of Butterfly Spreads Strategy
There are two main types of butterfly spread option strategy - Long butterfly spread in options and short butterfly spread strategy. Let's learn them in detail with example
1) Long Butterfly Spread Strategy
In this long butterfly spread option strategy, the risk and reward both are limited. It involves buying one low-strike option contract and selling two middle strike option contracts. By creating this position, max profit is received if the option closes or expires near the middle strike price. It is best suited when traders are expecting no or little price movements before the expiry of the contract.
2) Short Butterfly Spread Strategy
This one is the opposite of the long butterfly spread strategy. In this strategy trader sells one low strike option contract and buys two middle strike option contracts. This is useful when the price of the asset is expected to move away from the middle strike price at the time of expiry.
How do Traders Benefit from the Butterfly Spread Strategy ?
Traders get many benefits by implementing the long or short butterfly spread option strategy, a few of which are listed below :
1) Low-risk exposure
The risk on the position is predetermined and occurs only when the asset moves away from the middle strike price.
2) Profits in the stable market
This butterfly spread strategy allows traders to make a profit from the stable markets.
3) Flexibility
Traders can modify the position as per the different market conditions, their goals, and risk-bearing capacity, by changing the strike prices and expiry dates of the option contracts.
4) Low requirement for capital
As this long and short butterfly spread option strategy involves multiple legs, the margin requirement is low compared to any other options trading strategy. The potential loss is covered by the net received by selling the contracts.
How Does Butterfly Spread Option Strategy Work ?
The butterfly spread strategy works by combining the option contracts with 3 different strike prices, they are as follows :
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Buy one contract at a lower strike option
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Sell two contracts at middle strike options
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Buy one contract at a higher strike option
By creating the long or short position in this way, traders can make a perfect risk-reward scenario and can achieve maximum profit; if the contract expires or closes near the middle strike price.
Advantages and Disadvantages of Butterfly Spread Strategy
Advantages :
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Predetermined risk and reward, traders know in advance about the money they might lose in adverse market conditions
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butterfly spread option strategy works perfectly fine in stable market scenarios and low volatile markets
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The capital requirement is low compared to the straddles and strangles strategies.
Disadvantages :
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The upside profit is capped, so even if the price of the asset moves higher, the reward is capped.
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Few traders find long or short butterfly spread strategy complex to execute due to multiple legs
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Traders must have a deep market understanding to forecast the price of the asset, and to ensure that it will stay within the middle strike price to make a profit
Understanding Butterfly Spread Option Strategy with Payoff Diagram
The butterfly spread option strategy payoff diagram helps traders to visually understand the profit and loss at different strike price levels at the time of expiry.
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At the lower and higher strike prices, losses are limited.
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At the middle strike price, the trader earns the maximum profit.
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If the price moves significantly beyond the strike prices, the trade results in a loss.
Butterfly Spread Option Strategy Example
To better understand the execution of the long and short butterfly spread strategy, let us consider a hypothetical example below :
Consider the call option contract trading at ₹100
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Buy 1 call option contract at ₹ 95 for ₹ 6
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Sell 2 call options contracts at ₹ 100 for ₹ 3 each
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Buy 1 call option contract at ₹ 105 for ₹ 1
Total cost (net debit): ₹ 6 - ( ₹ 3 × 2) + ₹ 1 = ₹ 1
Potential Outcomes as for example :
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If the asset stays at ₹100 (middle strike price), then the trader earns the maximum profit.
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If the asset moves significantly above or below ₹ 100, the losses are limited to the net premium paid ( ₹ 1)
How to Trade a Butterfly Spread in Options ?
The execution of the butterfly spread strategy must be easy after the example explained above, but here are the simple steps to follow while execute long or short butterfly spread option strategy if you are a beginner
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Select the 3 different strike prices of the option contract you want to trade having equal intervals
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Ensure that the market is not highly volatile
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Buy/sell the option contracts in an appropriate ratio, not leading to a net loss
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Keep track of the live prices in the market and modify the positions if needed.
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Close the trade at expiry or exit before expiry if the market does not favor your position
Conclusion
The butterfly spread option strategy is one of the best option for traders who are looking for low-risk and fixed profit. Whether using a long butterfly spread strategy in a low-volatility market or a short butterfly spread in a high-volatility scenario, implementing this butterfly spread in options helps traders navigate the different levels of market volatility.