Entering a trade always presents a risk. Knowing how to manage that risk is why traders and investors have invented trading strategies. They help them keep their emotional response in check while providing a certain level of security against enormous losses.
The straddle and the strangle are some of the more straightforward trading strategies. However, in this article, we will talk about the six butterfly options strategies, how they work, and how you can use them to protect your investment.
What Is the Butterfly Trading Strategy?
The butterfly trading strategy, also called “the butterfly spread,” is a neutral options strategy that combines bull and bear spreads. It involves the undertaking of four different option positions or contracts simultaneously.
You can implement this strategy using only call, put options, or even combine them. The important thing is that the options have the same expiration date and three different strike prices.
This strategy provides a fixed risk and capped profits and losses. The three different strike prices this strategy uses are defined as:
- Higher strike price (out-of-the-money)
- At-the-money strike price (the strike price and the actual market price are the same)
- Lower strike price (in-the-money)
The term out-of-the-money signifies that the call option has a strike price higher than the actual market price of the stock or asset. The term in-the-money means the opposite - the strike price is lower than the actual market price of the asset or stock.
The options with higher and lower strike prices are equally distanced from the options with at-the-money strike prices.
Combining call and put options, this strategy can provide a profit depending on the high or low volatility of the price of an underlying asset. This is why there are several butterfly options strategies that we will take a look at next.
Types of Butterfly Options Strategies
This section will examine the six butterfly spread options strategies you can trade with. They involve using only call and put option types or both simultaneously.
Long call butterfly spread
You can implement the long call butterfly strategy by combining four call options with three different strike prices. It looks something like this:
- You buy one out-of-the-money call option
- You sell two at-the-money call options
- You buy one in-the-money call option
The long call butterfly spread strategy is profitable when the underlying asset's market price is stagnant or experiences low volatility. When you invest using this strategy, you should expect the market price to remain close to the ATM strike price at expiration.
The maximum profit you can gain from this strategy is the difference between the ATM strike price and the ITM strike price minus the costs for commissions.
The maximum risk of loss is limited to the initial cost of the options contracts (the premium) plus commissions.
Short call butterfly spread
The short call butterfly spread functions similarly to the previous strategy but in reverse order. It uses four call options, but in the following combination:
- You sell one out-of-the-money call option
- You buy two at-the-money call options
- You sell one in-the-money call option
Unlike the long call butterfly spread, this strategy will result in being profitable if the future volatility of the underlying asset’s price is higher than the implied volatility. This means that the more the market prices move away from the at-the-money strike price, the more profitable the strategy will be.
Compared to the previous strategy, the short call butterfly spread implements the at-the-money strike price as the extended position and the OTM and ITM strike prices as the short positions.
Long put butterfly spread
The long put butterfly spread works oppositely from the long call butterfly spread. This strategy is initiated when:
- You buy one in-the-money put option
- You sell two at-the-money put options
- You buy one out-of-the-money put option
Starting this trading strategy creates a net debt, and both the potential loss and profit are limited.
The maximum profit you can gain from this strategy equals the difference in the highest and center strike prices minus the premium paid for the put options and commissions.
The maximum loss of this strategy is the premium paid for the put option contracts, including the cost of commissions.
Short put butterfly spread
The short put butterfly spread works reverse from the long put butterfly spread. This strategy is created when:
- You sell one in-the-money put option
- You buy two at-the-money put options
- You sell one out-of-the-money put option
Similar to the long call butterfly spread, this strategy results in profit when the price of the underlying asset or stock closes above the highest strike price or below the lowest strike price at the time of expiration. In both cases, you keep the net credit minus commissions as profit.
The maximum risk from the short put butterfly spread strategy can be calculated as the difference between the ATM and ITM strike prices, minus the value of the net credit and commissions, at expiration.
Iron butterfly spread
Both the iron butterfly and the reverse iron butterfly spread strategies use a combination of call and put options to initiate the trading. The iron butterfly strategy is initiated when you:
- Buy an out-of-the-money put option with a lower strike price
- Sell an at-the-money put option
- Sell an at-the-money call option
- Buy an out-of-the-money call option with a higher strike price
As a result of this strategy, a net credit is formed. Profitability is expected if the underlying asset's value remains close to the middle or at-the-money strike price.
The maximum profit gains from this strategy can be calculated as the difference between the highest or the lowest strike prices and the middle strike price minus the net credit and commissions. The maximum loss can equal the net credit plus the commission costs.
Reverse iron butterfly spread
In the case of the reverse iron butterfly spread, the opposite happens. You initiate a reverse iron butterfly spread when you:
- Sell an out-of-the-money put option with a lower strike price
- Buy an at-the-money put option
- Buy an at-the-money call option
- Sell an out-of-the-money call option with a higher strike price
A net credit is once again created as a result of this strategy, but this time, it is best suited for market situations where the underlying asset price is highly volatile.
Maximum profit with this strategy is expected if the underlying asset's value moves above the higher strike price or below the lower strike price. The gain is then calculated as the strike price of the sold call minus the strike price of the bought call, without including the premiums paid.
The maximum loss from this strategy is the premium you pay for the call and put options to attain your position.
How Does the Butterfly Compare to the Straddle?
The butterfly is a different strategy from the straddle.
The butterfly strategy involves buying and selling call and put options with different strike prices. Unlike them, the straddle only involves calls and puts with the same strike price.
In practice, traders use straddle more often when they predict more volatile price movements of particular assets. On the other hand, butterfly strategies are used for less volatile price markets.
Another essential difference between the two strategies is the profit and loss restrictions. While the butterfly strategy limits the profits and losses, the straddle provides an unlimited loss or profit potential.
The breakeven points are also different for both strategies. Breakeven points are the areas where the profit equals the initial premium you paid for the call and put options.
For the butterfly, these breakeven points are calculated as the lower strike price plus the premium or the higher strike price minus the premium. On the other hand, the breakeven points for the straddle are strike price plus or minus the premium.
Who Is the Butterfly Options Strategy Suited For?
The butterfly options strategies are complex systems that require a decent amount of practical experience. That is why they are suited for intermediate to experienced traders and investors.
It doesn’t matter that the strategy provides a limited risk for profit or loss. A deeper understanding of technical terms and market price movements is needed to use it to its full potential.
The butterfly strategies are often affiliated with terms such as Gamma, Theta, Vega, Rho, etc. These are called “ Greeks,” and initial knowledge concerning them is also required.
Conclusion
Options trading involves using the right strategies for specific market conditions. Just as the straddle is used for highly volatile price markets, the butterfly options strategies seem more efficient in markets where the prices are more stable.
Nevertheless, the six strategies are quite complex and require a deep practical understanding and experience. Choose to implement one in your trading routine only if you deeply know what you are doing.
A platform like FoolProof Options will provide you with an even greater level of security and minimized risk, especially if you’re a beginner trader. Make sure to give it a shot, and try one of the butterfly options strategies there.