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Understanding Butterfly Options

A s an experienced options trader, you have several strategies that you can use to your advantage. For example, if used correctly, a butterfly spread comprises several tactics that can help you make a profit with different volatility levels. Read on to learn more about a butterfly spread and the various butterfly options strategies.

  • A butterfly spread refers to a neutral options strategy that uses both bull and bear spreads, all while having a maximum profit and maximum risk.
  • Butterfly spreads utilize four calls or four puts with identical expirations and three distinct strike prices.
  • Also known as the iron fly, the iron butterfly is an advanced options strategy wherein you buy and hold four different options at three distinct strike prices.
  • The long-call butterfly refers to a three-part options strategy that uses both a long- and a short-call spread.

What Is a Butterfly Spread?

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A butterfly spread refers to a neutral options strategy that uses both bull and bear spreads, all while having a maximum profit and maximum risk. While bull spreads aim to profit from the moderate rise in a security or asset, bear spreads try to profit from their decline. With four calls or four puts, butterfly spreads prove advantageous when the underlying doesn’t move before the option expires.

How Does a Butterfly Spread Work?

Butterfly spreads utilize four calls or four puts with identical expirations and three distinct strike prices. Strike prices refer to the set price in which a call or put can be purchased or sold when exercised. These three strike prices are as follows:

  • Higher strike price
  • At-the-money strike price
  • Lower strike price

The distance from the higher strike price to the at-the-money strike price is the same as the distance from the lower strike price to the at-the-money strike price. For example, let’s say you have $45 at the lower strike price, $50 at the at-the-money strike price, and $55 at the higher strike price. Both the higher strike price and lower strike price are $5 away from the at-the-money strike price of $50.

Keep in mind that when you combine calls and puts for a butterfly spread, you can create various types of butterfly spreads. These spreads aim to make a profit from volatility or low volatility.

Long-Call Butterfly vs. Short-Call Butterfly

The long-call butterfly refers to a three-part options strategy that uses both a long and a short call spread. It occurs when you buy a call with a lower strike price, sell two with a higher strike price, and buy one with a strike price that’s even higher. When you enter the trade, it creates a net debt. To gain a maximum profit, the price of the underlying at expiration needs to be the same as that of the written (sold) calls. The maximum loss for this strategy is the sum of the initial premiums and commissions.

In contrast, a short-call butterfly refers to a three-part strategy that occurs when you sell one call with a lower strike price, buy two with a higher price, and sell one with a price that’s even higher than that. As opposed to long-call butterflies that aim for a net debt, short-call butterflies are established for a net credit. For the position to maximize its profit, the stock price needs to be above the highest strike or below the lowest on the expiration day. The maximum loss for this strategy is the strike price for the call that was purchased sans the lower strike price, less the collected premiums.

Long-Put Butterfly vs. Short-Put Butterfly

The long-put butterfly spread strategy involves buying a put at a higher strike price, selling two with a lower strike price, and purchasing another with a strike price that’s even lower. When you enter the position, you get a net debt. As with the long-call butterfly strategy, the long-put butterfly comes with a maximum profit if the underlying security maintains the same strike price as the middle options. The maximum loss for the long-put butterfly is the number of commissions and the initial premium.

In comparison, the short-put butterfly strategy involves three key elements: buying a put with a high strike price, buying two with a lower strike price, and selling another with a strike price that’s even lower. As with the short-call butterfly, the short-put butterfly is created for net credit. When it comes to this strategy, the maximum profit is the collected premiums, while the maximum loss is the higher strike price sans the strike of the put that was purchased, less the collected premiums.

What Is the Iron Butterfly?

Also known as the iron fly, the iron butterfly is an advanced options strategy wherein you buy and hold four different options at three distinct strike prices. It aims to take advantage of stocks or futures prices that travel within a certain range. It uses both a bear call spread and a bull put spread with the same expiration date that meets at a strike price in the middle. The iron butterfly limits both risk and profit. To make the most of this options strategy, use it when there’s a lower price volatility.

While the iron butterfly is a credit spread, the regular butterfly spread is a type of debit spread. As opposed to the butterfly spread, the iron butterfly requires four contracts instead of three.

What Is the Reverse Iron Butterfly?

This volatile options trading strategy aims to make a profit when the underlying stock price falls or rises sharply. It is overall a low-risk, low-profit strategy. To use it, you need to write out-of-the-money calls, buy at-the-money calls, write out-of-the-money puts, and buy at-the-money puts.

This strategy works best for high-volatility situations since it creates a net debit trade. To get the maximum profit, you need the underlying’s price to go above or below the upper or lower strike prices. It comes down to the strike price of the written call sans the purchased call’s strike price, less the premiums you paid. The risk incurred is the premium you paid for the position.

What Are the Benefits of the Iron Butterfly?

When you use the iron butterfly, there are several advantages to consider. If these benefits seem worth the risk, consider putting this options strategy to use. Here are the advantages that come from the iron butterfly:

  • You don’t need a large amount of capital to create it.
  • It provides you with a regular income and far less risk compared to directional spreads.
  • You can roll iron butterflies up or down as needed.
  • You can close out half of the position and earn a profit from what’s left of the bear call or bull put spread.
  • It comes with clear risks and rewards.

What Are the Disadvantages of the Iron Butterfly?

While iron butterflies present a variety of benefits for options traders, they also come with a fair share of disadvantages. Understanding the cons of this strategy can help you determine if you should implement the iron butterfly moving forward. Here are the drawbacks of the iron butterfly:

  • You need four positions to be opened and closed, as opposed to three with the butterfly strategy.
  • You rarely make the maximum profit because the underlying usually ends up between the middle and upper strike price or middle and lower strike price.
  • You have a greater chance of obtaining a loss since this strategy is often established with narrow spreads.

Now that you understand the various butterfly options, consider if these strategies can help you find success as a stock market trader. Determine if the benefits outweigh the cons before moving forward.