Butterfly Spreads 101
What Is A Butterfly Spread
Many people view trading as a high-risk, high-reward activity, and while it can be risky, the potential rewards are often worth the risk. Finding the right strategies for these challenging market conditions can greatly increase your chances of trading profitably and help reduce the risks associated with trading. Butterfly Spreads are valuable tools for traders to have in their tool belts. Often times, they allow traders to generate income with a favorable risk to reward ratio. This blog will cover the basics of butterfly spreads!
What Is A Butterfly Spread?
A butterfly spread is an options strategy that gets its name from the shape of the profit/loss graph it produces. There are many ways to implement a butterfly trading strategy. A trader may buy a butterfly spread to open a position using calls, this is known as a long call butterfly. Selling a butterfly to open a positing using calls is known as a short call butterfly. The same is true for the use of puts. Buying puts to open a position is known as a long put butterfly, while selling puts in a butterfly spread is known as a short put butterfly. Each of these strategies has it’s own place in a traders tool belt.
Long call butterfly spread:
This strategy is used when the trader believes the underlying asset price will rise.
For example: to create a long call butterfly spread, a trader would buy one call option with a strike price of $100, sell two call options with a strike price of $105 and buy one call option with a strike price of $110. If the underlying asset’s price at expiration is above $105 and below $110 at expiration, the trader will make a profit. The maximum profit potential is limited to the credit received and occurs if the underlying asset’s price at expiration is precisely equal to the strike price of the sold options. The maximum loss is limited to the cost of the trade.
Short call butterfly spread:
This strategy is used when the trader believes the underlying asset’s price will fall.
To create a short call butterfly spread, the trader would sell one call option with a strike price of $100, buy two call options with a strike price of $105 and sell one call option with a strike price of $110. In order for this strategy to profit, the price of the underlying asset must be below $105 or above $110. The maximum profit is the net credit received minus commissions paid to the broker.
Trading butterfly spreads
Butterfly spreads can be traded using a variety of different methods. Some traders sell butterfly spreads as a larger strategy to generate income, and others buy butterfly spreads as low risk high reward lotto tickets for pinning trades.
When trading, it is essential to remember that long butterfly trades are profitable when the price of the underlying asset is within the wings of the butterfly. Short butterfly trades are profitable when the underlying asset price is outside the wings at expiration.
Selling butterfly spreads
Butterfly spreads can also be sold. The profit or loss from selling a butterfly spread will depend on several factors, including the strike prices of the options involved, the current price of the underlying asset, and the time remaining until expiration. The goal in selling a butterfly spread is to sell it for a credit and buy it back for less. Sometimes it is possible to let the spread expire if you are using a cash settled option like SPX.
Risks Involving butterfly spread
One of the best reasons to use butterfly spreads is the risk to reward ratio. An out-of-the-money long call butterfly spread can be purchased for a fraction of the price of a long call. The caveat to buying inexpensive spreads is that there is little room for error. If the underlying asset price closes outside of the spread, the trade will expire worthless, and you will have lost all of your money.
The most significant risk involved in a long butterfly spread is that the underlying asset price will move too far in one direction or the other, resulting in a loss. Therefore, when using Butterfly Spread, it is important to understand how far the price is likely to move so that you can choose appropriate strike prices. The expected move for the underlying asset can usually be found within the options chain.
Finally, remember that butterfly spreads are complex trades and can be challenging to execute. If you are new to options trading, you may want to consider using a paper trading account to become familiar with opening and closing these types of spreads.
Benefits associated with Butterfly Spread
Butterfly spread can be a helpful tool for options traders despite the risks involved.
A butterfly spread is an options trading strategy that gets its name from how the trade is structured, similar to a butterfly’s shape. The difference in strike prices between the long and short options creates a “wingspan.” The trader’s profit potential is greatest when the underlying asset’s price at expiration is equal to the strike price of the middle leg. That’s because all three options would then be at the money, and the trader would keep the entire premium from selling the two wings. While the butterfly spread has limited profit potential, it can still be a profitable trade if done correctly.
One of the best ways to trade butterfly spreads is by using zero days to expiration (0DTE) options like SPX. These options are liquid and have great spreads. Using a 0DTE butterfly spread can be a great tool for pinning the close on SPX but can also be sold for a credit and bought back for cheaper. However, you choose to trade a butterfly spread, you should give the trade the highest probability of working out by watching overall market conditions and choosing price levels based on areas of support or resistance.
The maximum profit for a long butterfly spread is realized when the underlying asset’s price at expiration is equal to the strike price of the middle leg. All three options would then be at the money, and the trader would keep the entire premium from selling the two wings.
The maximum loss for a long butterfly spread is realized when the underlying asset price goes up or down too much.
Butterfly spreads can be used for earnings if you are familiar with the underlying asset that you’re trading and know it’s “personality”. This would mean that you have identified major areas of support and resistance and have a general idea which way the stock will move. This strategy is not ideal for earnings trades. Unbalanced butterfly spreads, or verticals would be more suitable as you only need to be right about the direction of the movement, and not the price specifically.
The best time to trade butterfly spread is when the markets are relatively stable, and there is little news that could move the markets.
Butterfly spread is a complex options trading strategy that can be used to generate income or profit from a directional move in the price of the underlying asset. The trade is structured so that there are two wings and one Iron Condor. The iron butterfly spread is a more complex trade than the regular butterfly spread and should only be used by experienced traders. When done correctly, butterfly spread can be a profitable way to trade the markets. However, it is important to remember that this is a complex strategy, and you should only use it if you are confident in your ability to execute it correctly. Thanks for reading! We hope this article has helped you better understand what a butterfly Spread is. If you have any questions, please feel free to leave them in the comments below. Happy trading!