Butterfly Spread

A Butterfly Spread is a neutral options strategy utilized in cases when an investor anticipates little to no movement in the underlying stock's price. This strategy combines both a bull spread and a bear spread, and it has limited risk and limited profit potential. This strategy profits from low volatility and is most profitable when the stock price stays near the middle strike price at expiration.

Structure of a Butterfly Spread

There are three strike prices involved in this strategy and a total of four options contracts (which are either calls or puts):

1. Buy 1 call (or put) at a lower strike price.

2. Sell 2 calls (or puts) at a middle strike price.

3. Buy 1 call (or put) at a higher strike price.

All the options have the same expiration date.

Types of Butterfly Spreads

There are two major types:

Call Butterfly Spread: Uses call options.
Put Butterfly Spread: Uses put options.

Both types function in the same way and result in a neutral strategy, though the investor can use either based on his preference or options available at that time.

Butterfly spread options investment strategy

Profit and Loss

Max Profit: This occurs if the stock price is equal to the middle strike price at expiration.
Max Loss: This occurs if the stock price is outside the range defined by the lower and higher strike prices.
Breakeven Points: There are two breakeven points - one above and one below the middle strike price.

Illustration Using Apple Stock (AAPL)

Lets assume Apple stock is trading at $180, and the investor believes that the stock will stay near this price until expiration. He decides to set up a Call Butterfly Spread:

1. Buy a 170 strike call: Costs $12 per share i.e. a total of $1200 for 100 shares.

2. Sell two 180 strike calls: The investor receives $6 per share for each i.e. a total of $1200 for 2 calls.

3. Buy a 190 strike call: It cost $2 per share i.e. a total of $200 for 100 shares.

Key Numbers:

Net Premium Paid: Total cost is $1200 (buying the 170 strike) + $200 (buying the 190 strike) - $1200 (Selling two 180 strikes) = $200.
Maximum Loss: The net premium paid, which is $200.
Maximum Profit: This occurs if Apple's stock is exactly $180 at expiration. In this case, the 170 strike call is worth $10 ($180 - $170), the 180 strike calls expire worthless, and the 190 strike call also expires worthless. This results in a max profit of $800 minus the $200 premium, or $600.

Butterfly spread options trading strategy

Possible Scenario Outcomes

1. Stock Price is $180 at Expiration: This is the best possible scenario outcome. The lower strike call (170) is worth $10, the middle strike calls (180) expire worthless, and the higher strike call (190) expires worthless. The investor makes the maximum profit of $600.

2. Stock Price is Below $170 of Above $190 at Expiration: Both the long and short calls expire worthless, and the investor loses the net premium paid, which is $200 - the investor's maximum loss.

3. Stock Price Between $170 and $180: The investor still makes a profit in this scenario but less than the maximum. For an instance, if Apple's stock ends at $175, the 170 strike call is worth $5, the 180 strike calls expire worthless, and the 190 strike call also expire worthless. The investor profit would be $500 (from the 170 call) minus $200 (premium paid), for a $300 profit.

4. Stock Price Between $180 and $190: The 170 strike is fully in the money, while the 180 strike calls start to gain value, and the 190 strike call remains out of the money. This reduces the profit potential as the short 180 strike calls create a liability. As the price moves closer to $190, the investor's profit shrinks.

Why Use a Butterfly Spread?

Limited Risk: The maximum loss is the net premium paid for the strategy.
Limited Profit: The potential profit is capped and only occurs if the stock remains near the middle strike price.
Neutral View: This strategy is ideal when the investor expects the stock price to remain relatively stable.

In Conclusion

A Butterfly Spread is a neutral strategy that benefits from low volatility. By using three different strike prices i.e. buying one lower strike, selling two middle strikes, and buying one higher strike, the investor creates a defined- risk trade where the best outcome occurs when the stock price stays near the middle strike price. Using the Apple stock as an illustration, this strategy allows you to profit from price stagnation, with limited downside and upside potential.