Butterfly Spread Option: A Comprehensive Guide with Examples

The name of this approach comes from the unusual butterfly-wing shape of its profit and loss diagram. In this article, we'll examine the idea of butterfly spreads in options trading, examine their physics, and provide real-world applications to illustrate how they might be used in trading.

Understanding Butterfly Spreads

An option trading technique known as a butterfly spread uses three contracts with the same type of option (all calls or all puts) and the same expiration date. Buying one option with a lower strike price, selling two options with a middle strike price, and then purchasing one option with a higher strike price make up the approach. The symmetric pattern on the options chain is produced by the strike prices' equal distances from one another.

Why Use Butterfly Spread Options

A butterfly spread's main goal is to make money from a certain range of prices for the underlying security. For this technique to be most effective, the underlying security price should be close to the middle strike price at expiration. The options sold at that strike price will expire worthless when the price is close to the middle strike, allowing the trader to keep the premium they received from their transaction. Due to their proximity to the value of the underlying security, the options purchased at the lower and higher strikes may simultaneously increase in value.

The use of butterfly spreads depends on the state of the market. They are frequently used when traders expect the underlying asset to have little volatility or a small trading range. By using the temporal value decay for the sold options and the possible appreciation of the bought options, this method enables traders to profit from such scenarios.

Example 1: Call Butterfly Spread

Let's consider an example to illustrate the application of a call butterfly spread. Assume stock ABC is trading at Rs.100, and an options trader expects the price to remain relatively stable in the near term. The trader decides to set up a call butterfly spread as follows:

1. Buy a call option having a strike price at Rs.60.
2. Sell two call options with a strike price of Rs.70.
3. Buy one call option with a strike price of Rs.80.

Each option carries a premium cost; the spread's starting price will depend on the net premium paid or received. Let's say the premiums are Rs.9, Rs.7, and Rs.4, respectively.

All options expire worthless if the stock price at expiration is below Rs.60 or above Rs.80, resulting in a maximum loss equal to the spread's initial cost (=Rs.9 + Rs.7 - Rs.4 = Rs.12). However, the technique begins to turn a profit in the Rs.60 to Rs.80 level.

The biggest profit would be made if the stock price at expiration was Rs.100 (the middle strike price). The two short call options would be exercised at this price, and the long call options would expire worthless. The profit would be the difference between the long and short call options' strike prices, less the spread's original cost.

Example 2: Put Call Butterfly Spread

To better grasp the adaptability of the approach, let's now look at a put butterfly spread example. Consider that an options trader believes the price of stock ABC, which is currently trading at Rs.80, will remain largely steady. A put butterfly spread is created by the trader as follows:

1. Buy one put option with a strike price of Rs.60.
2. Sell two put options with a strike price of Rs.70.
3. Buy a put option that has a Rs.80 strike price.

Assuming once more that premium costs are Rs.9, Rs.7, and Rs.4, respectively, the net premium received or paid establishes the spread's initial cost.

All options expire worthless if the stock price at expiration is below Rs.60 or above Rs.80, resulting in a maximum loss equal to the spread's initial cost (=Rs.9 + Rs.7 - Rs.4 = Rs.12). However, the approach begins to turn a profit in the Rs.60 to Rs.80 level.

Conclusion

Butterfly spreads are adaptable options trading methods with low risk and profit potential. Traders can build positions that profit from certain price ranges for the underlying asset by combining multiple options contracts with varying strike prices. The key to maximising the efficacy of the approach, whether using call or put options, is to be aware of the market forecast and select the proper strike prices. Butterfly spreads should only be used after careful research and consideration of market conditions, risk tolerance, and other factors. Financial services provider Share India offers traders and investors all-inclusive options trading solutions. They provide an app for options trading with all the tools to assist people in making knowledgeable choices on various trading strategies, such as the butterfly spread.