How To Use Butterfly Option Strategy?
What Is a Butterfly Spread?
A butterfly spread is an options strategy that combines both bullish and bearish elements.
It’s designed to have a fixed risk and capped profit.
Butterfly spreads thrive when the underlying asset remains near a specific price (usually the middle strike price) until option expiration.
They use four options contracts with the same expiration date but three different strike prices.
Components of a Butterfly Spread:
Higher Strike Price: Buy one in-the-money (ITM) option.
At-the-Money (ATM) Strike Price: Sell two options.
Lower Strike Price: Buy one out-of-the-money (OTM) option.
Types of Butterfly Spreads:
Long Call Butterfly Spread:
Buy an ITM call, sell two ATM calls, and buy an OTM call.
Profit: Maximized if the underlying price equals the written calls’ strike price at expiration.
Risk: Initial cost of premiums paid.
Short Call Butterfly Spread:
Sell an ITM call, buy two ATM calls, and sell an OTM call.
Profit: Limited to the premium received.
Risk: Unlimited if the underlying price rises significantly.
Implementing Butterfly Strategies:
Step 1: Market Assessment:
Choose a market scenario (low volatility or range-bound conditions).
Step 2: Strike Selection:
Pick strikes based on your outlook.
Ensure the upper and lower strikes are equidistant from the ATM strike.
Step 3: Calculate Costs and Profits:
Understand the maximum profit and loss.
Step 4: Risk Management:
Consider position sizing and exit points.
Visualizing the Butterfly:
The payoff resembles a butterfly’s wings, hence the name.
Profit is highest at the ATM strike and tapers off towards the outer strikes.
When to Use Butterfly Spreads:
Low Volatility: Ideal for markets with minimal price movement.
Neutral Outlook: Profit when the underlying stays near the middle strike.
Earnings Plays: Use around earnings announcements.
Remember that butterfly spreads are versatile and can be constructed using either calls or puts.
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