What Is a Butterfly Spread and How Does It Work?

Options trading involves contracts that derive their value from an underlying asset, such as a stock, exchange-traded fund, or commodity. These contracts offer traders the right, but not the obligation, to buy or sell an asset at a predetermined price by a specific date. The butterfly spread is a neutral strategy, typically characterized by limited risk and limited profit potential, making it suitable for specific market conditions.

Core Concept of a Butterfly Spread

A butterfly spread combines multiple option contracts using three different strike prices, all with the same expiration date, to form a single position. Its primary objective is to generate profit when the underlying asset’s price remains relatively stable and trades within a narrow, anticipated range until the options expire. This makes it particularly attractive in environments where significant price movements are not expected.

The fundamental idea behind a butterfly spread involves balancing the purchase and sale of options to define both the maximum potential gain and loss. This strategy entails buying options at the outer strike prices, often referred to as the “wings,” and simultaneously selling a greater number of options at the middle strike price, known as the “body.” This combination of long and short positions creates a structure that benefits from time decay and a lack of volatility, as the strategy is designed to profit from the underlying asset staying close to the middle strike price.

Structural Elements and Setup

These strike prices are typically equidistant from one another, meaning the difference between the lower and middle strike is the same as the difference between the middle and upper strike. This equidistant spacing helps in creating a symmetrical profit and loss profile. The strategy generally requires four option contracts.

A common way to set up a long call butterfly spread involves buying one in-the-money (ITM) call option at a lower strike price, selling two at-the-money (ATM) call options at a middle strike price, and buying one out-of-the-money (OTM) call option at a higher strike price. For example, a trader might buy a call with a strike of $90, sell two calls with a strike of $100, and buy a call with a strike of $110, all expiring in the same month.

Alternatively, a long put butterfly spread is constructed using put options. This involves buying one OTM put option at a higher strike price, selling two ATM put options at a middle strike price, and buying one ITM put option at a lower strike price. Using the previous example, a trader might buy a put with a strike of $110, sell two puts with a strike of $100, and buy a put with a strike of $90, also with the same expiration date. Both call and put butterfly spreads aim for the same neutral market outcome. The defined structure means that the maximum potential profit and loss are known at the outset of the trade.

Profit and Loss Profile

The maximum potential profit for a long butterfly spread occurs when the price of the underlying asset is exactly equal to the middle strike price at the time of option expiration. In this ideal scenario, the two options sold at the middle strike expire worthless, while the purchased options generate the maximum possible value. The maximum profit is generally calculated by taking the difference between the middle strike price and the lower strike price, then subtracting the net premium paid when initiating the spread. For example, if the strikes are $90, $100, and $110, and the net premium paid was $2, the maximum profit would be $10 – $2 = $8 per share.

The maximum potential loss for a long butterfly spread is limited and occurs if the underlying asset’s price moves significantly above the upper strike price or significantly below the lower strike price at expiration. In these extreme scenarios, the combination of long and short options results in a net loss equal to the initial premium paid for establishing the spread.

A long butterfly spread has two break-even points, which are the prices at which the trade neither makes a profit nor incurs a loss. The lower break-even point is calculated by adding the net premium paid to the lower strike price. For instance, if the lower strike is $90 and the net premium paid is $2, the lower break-even point is $92. The upper break-even point is determined by subtracting the net premium paid from the upper strike price. Using the same example, if the upper strike is $110 and the net premium is $2, the upper break-even point is $108.

The profit and loss diagram for a long butterfly spread resembles a bell shape, with the peak profit occurring at the middle strike price and losses flattening out beyond the upper and lower break-even points. This shape visually represents the limited profit and limited loss nature of the strategy.

Market Expectations for Use

The butterfly spread is primarily employed when a trader anticipates that the underlying asset will experience low volatility and trade within a relatively tight price range until the options expire. Traders often use this strategy when they believe the market has already priced in most of the expected news or events related to the asset, leading to a period of consolidation.

The strategy benefits from time decay, also known as theta decay, as the value of the options sold at the middle strike erodes more quickly than the value of the purchased options, assuming the price remains near the body. For instance, before a major earnings announcement or a regulatory decision that could drastically impact the stock price, a butterfly spread would typically be less effective.