Definition
A Butterfly Spread is a neutral options strategy combining bull and bear spreads, which involves buying or selling four options of the same type across three strike prices. It is designed to achieve a profit when the price of the underlying asset remains close to the middle strike price, limiting both the risk and potential profit. The pattern of gains and losses at expiration resembles a butterfly shape, hence the name.
Key Takeaways
- A Butterfly Spread is an advanced options strategy often used when a trader anticipates a certain price range within which a financial asset will trade over a specific time period.
- It involves the simultaneous purchase and sale of either call or put options that share the same underlying asset and expiration date but have different strike prices. Thus, it includes two options with a lower strike price, one option with a medium strike price, and one option with a higher strike price.
- The goal of a Butterfly Spread strategy is to earn limited profit if the underlying asset’s price shifts drastically in either direction. It has limited risk, but also limited profit potential, thereby making it a cost-effective strategy for traders seeking to profit from a specific price area.
Importance
The finance term “Butterfly Spread” is important because it’s a neutral option strategy that involves minimal risk.
This strategy is used when investors anticipate minimal price changes on a security in a specific timeframe.
It is a combination of bull and bear spreads, consisting of three strike prices with the same expiration date.
This combination results in low probability high reward outcome if the security’s price remains unchanged up till options expiry.
Hence, understanding the butterfly spread is critical for investors looking to profit from little or no changes in asset prices, allowing for strategic investment planning and risk management.
Explanation
The primary purpose of a butterfly spread, a neutral options strategy made up of multiple options trades, is to profit on moderate price swings of the underlying asset. This strategy aims to exploit high volatility by gaining high premiums without incurring high costs. The trader aims to capitalize on a security’s price and expects minor price changes in the future.
It is said to offer high returns due to the minimal risk involved, offering a high reward-to-risk ratio. It allows investors to create a non-directional, low-risk trading strategy, which can provide limited returns. The butterfly spread is commonly used when an investor is forecasted to have a particular directional view on the market or a specific security.
For instance, if a trader anticipates that the price of a particular security will rise moderately in a given period, they could implement a long call butterfly spread strategy to earn a profit. On the other hand, if they expect the prices to remain steady or change only very slightly, using a short butterfly spread might be the most profitable. It’s a versatile strategy that adapts to diverse market conditions, thus suitable for a vast range of investors.
Examples of Butterfly Spread
Butterfly spread strategy it’s a neutral strategy which involves placing four option trades on the same asset simultaneously. Here are three real world examples illustrating its application:Butterfly Spread in Stock Options: An investor believes that Apple’s (AAPL) stock price will stay relatively neutral over the next month. They could use a butterfly spread strategy by purchasing an in-the-money call option at $135, sell two at-the-money call options at $145, and buy an out-of-the-money call option at $Here, the investor can profit if the stock price stays around $145, which is the point of maximum profit.
Commodity Trading: Suppose a commodities trader predicts that the price of gold will have limited movement over the next two months. They could implement a butterfly spread strategy by buying a gold futures contract for $1200, selling two contracts for $1300, and purchasing another contract for $The maximum profit occurs if the gold price stays at $Forex Market: A forex trader could implement a butterfly spread in currency trading. For instance, if the trader believes the USD/JPY pair will remain relatively stable at around
00, they could buy a call option with a strike price of $00, sell two call options with a strike price of $00, and buy another call option with a strike price of $
Profits are maximized if the exchange rate stays at
FAQs on Butterfly Spread
What is a Butterfly Spread?
Butterfly Spread is a neutral option strategy that involves the combination of a bull spread and a bear spread. It is mainly used by traders who predict minimal movement in the price of the underlying asset.
How is a Butterfly Spread set up?
A Butterfly Spread is set up by buying an out-of-the-money call option, selling two at-the-money call options, and buying one in-the-money call option of the same expiry date. The strike prices of these options form a range that can determine the potential profit and loss.
What is the risk and reward involved in a Butterfly Spread?
The risk involved in a Butterfly Spread is limited to the net premium paid initially to set up the spread. The maximum reward is achieved when the price of the underlying asset at expiry is equal to the strike price of the options sold.
Why is it called a Butterfly Spread?
It is called a Butterfly Spread because of its payoff diagram which resembles a butterfly. The two peaks of the profit line (formed when the spread is established) represent the butterfly’s wings and the low point depicts its body.
When should a trader use a Butterfly Spread?
A Butterfly Spread should be used when a trader has a neutral outlook on the market, i.e, he/she expects the underlying asset to not move significantly in the foreseeable future.
Related Entrepreneurship Terms
- Options Contract
- Long Position
- Short Position
- Strike Price
- Expiration Date
Sources for More Information
- Investopedia: A comprehensive online resource for understanding finance and investing terms and strategies.
- The Balance: Provides expertly written, practical advice on personal finance and investing.
- CNBC: A recognized world leader in business news, providing real-time financial market coverage and business content.
- Bloomberg: A global leader in finance news and information, they provide valuable insights into the world of finance and investing.
