What is a Butterfly Option Trading Strategy

A long Butterfly Option Trading Strategy is a limited risk, non-directional options strategy that is designed to earn big (but limited) profits but with a low probability. The long Butterfly spread also wins when the future volatility of the underlying is expected to be lower from the current implied volatility. Just as there are several ways onf constructing a butterfly, there are may ways a trade them for both income as well as speculative/directional option trading.

Let’s start with the fundamentals of the butterfly spread (following is an example of SPX)-

  1. Buy SPY $115 Calls and
  2. Sell SPY 2x $117 Calls and
  3. Buy SPY $119 Calls

In simple terms, Sell the Body and Buy the Wings. This is a Debit spread requiring investment of $35 only. However, there is only 22.5% probability that this trade can make money.

Here is how the risk reward curve for this spread looks like. As you will notice, if someone can accurately predict underlying move, a butterfly spread can be very rewarding (In the below example, the SPY $117 call butterfly can yield over +400% if SPY is at $117 by April Expiration. Why does Butterfly spread make so much money if the underlying remains at short strike by expiration? It’s because At the Money (ATM) option has the highest time premium (aka extrinsic value) and you are selling 2 of those for each butterfly thus making it theta positive.

Butterfly Explaination

How about the greeks? Below table summarizes the Greeks, break even points as well as yield of this butterfly spread.

SPY Butterfly Greeks

It is delta neutral (at the start), Gamma negative, theta positive and vega negative. To explain it simply, the trade will make money if SPY stays within $115.36 and $118.64 by April 2010 expiration. Before expiration, assuming SPY stays at the same place, it will make money with the time decay as well as implied volatility drop.

This makes the long butterfly a good neutral option strategy for low volatility, assuming you are expecting stock price not moving much in order to collect maximum profits. It is also a low-risk strategy, since your losses are limited if the stock crashes or climbs unexpectedly. The long butterfly can also be created using all put options instead of all call options.

The key with butterfly spread is to book profit quickly and move on to the next opportunity. Don’t be greedy to book all the gains till expiration as even a single day’s large move can throw a positive trade into losing territory.

Broken wing Butterfly (BWB), ATM Butterfly, Iron Fly, Out of the Money Butterfly, 1 or 2 Skip Butterfly etc are several variations based on the similar concept. Later I shall talk about how one can use Butterfly Option Trading strategy for speculation as well as income generation.


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6 responses to “What is a Butterfly Option Trading Strategy”

  1. Nupur Avatar
    Nupur

    please explain iron condor and buffterfly option startegy.
    how to implement on options with help of practical example

  2. OptionPundit Avatar

    Nupur above example is a read trade butterfly example; one more is here – https://www.optionpundit.net/iron-condor/how-to-play-google-earnings-2

    More are listed here-> https://www.optionpundit.net/articles; pls search “Iron Condor” on this site and there are many examples. Pls let me know if you need help.

  3. pt Avatar
    pt

    Hi,
    Could you please provide more info on how to apply butterfly strategies to directional/speculative trading? I didn’t find too much info dealing with this subject specifically . Thanks

  4. Jeff Perkins Avatar
    Jeff Perkins

    How would one handle the opposite – that is when volitility is expected around a certain date ( say August 2, 2011); the likelyhood of up = 65% and down = 35%?

  5. OptionPundit Avatar

    Dear Jeff,

    Could you pls explain your question with more details? I am not sure if I understand it correctly to provide my detailed thoughts?

    Thanks.

  6. Priyanka Avatar
    Priyanka

    Hi….
    Can you please explain butterfly strategy underline principle? Why we use this strategy? Even though iron Condor is also there but How differ with iron Condor.

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